Individual Finance PDF

Individual Finance
v. 1.0
This is the book Individual Finance (v. 1.0).
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ii
Table of Contents
About the Authors................................................................................................................. 1
Acknowledgments................................................................................................................. 3
Dedications ............................................................................................................................. 4
Preface..................................................................................................................................... 5
Chapter 1: Personal Financial Planning......................................................................... 10
Individual or “Micro” Factors That Affect Financial Thinking ............................................................... 14
Systemic or “Macro” Factors That Affect Financial Thinking ................................................................ 20
The Planning Process................................................................................................................................... 29
Financial Planning Professionals ............................................................................................................... 39
Chapter 2: Basic Ideas of Finance .................................................................................... 43
Income and Expenses................................................................................................................................... 44
Assets............................................................................................................................................................. 52
Debt and Equity ............................................................................................................................................ 57
Income and Risk ........................................................................................................................................... 63
Chapter 3: Financial Statements...................................................................................... 65
Accounting and Financial Statements ....................................................................................................... 66
Comparing and Analyzing Financial Statements ..................................................................................... 79
Accounting Software: An Overview ........................................................................................................... 98
Chapter 4: Evaluating Choices: Time, Risk, and Value ............................................. 104
The Time Value of Money ......................................................................................................................... 105
Calculating the Relationship of Time and Value .................................................................................... 108
Valuing a Series of Cash Flows.................................................................................................................. 115
Using Financial Statements to Evaluate Financial Choices ................................................................... 126
Evaluating Risk ........................................................................................................................................... 132
Chapter 5: Financial Plans: Budgets ............................................................................. 138
The Budget Process.................................................................................................................................... 139
Creating the Comprehensive Budget ....................................................................................................... 143
The Cash Budget and Other Specialized Budgets ................................................................................... 155
Budget Variances ....................................................................................................................................... 160
Budgets, Financial Statements, and Financial Decisions ....................................................................... 167
iii
Chapter 6: Taxes and Tax Planning............................................................................... 171
Sources of Taxation and Kinds of Taxes .................................................................................................. 172
The U.S. Federal Income Tax Process ...................................................................................................... 179
Record Keeping, Preparation, and Filing................................................................................................. 191
Taxes and Financial Planning ................................................................................................................... 199
Chapter 7: Financial Management ................................................................................ 204
Your Own Money: Cash.............................................................................................................................. 206
Your Own Money: Savings ........................................................................................................................ 208
Other People’s Money: Credit ................................................................................................................... 217
Other People’s Money: An Introduction to Debt .................................................................................... 231
Chapter 8: Consumer Strategies .................................................................................... 237
Consumer Purchases.................................................................................................................................. 238
A Major Purchase: Buying a Car ............................................................................................................... 254
Chapter 9: Buying a Home............................................................................................... 266
Identify the Product and the Market ....................................................................................................... 267
Identify the Financing ............................................................................................................................... 280
Purchasing and Owning Your Home ........................................................................................................ 291
Chapter 10: Personal Risk Management: Insurance.................................................. 298
Insuring Your Property ............................................................................................................................. 300
Insuring Your Health ................................................................................................................................. 311
Insuring Your Income................................................................................................................................ 323
Chapter 11: Personal Risk Management: Retirement and Estate Planning ......... 333
Retirement Planning: Projecting Needs .................................................................................................. 334
Retirement Planning: Ways to Save ......................................................................................................... 342
Estate Planning........................................................................................................................................... 352
Chapter 12: Investing ....................................................................................................... 359
Investments and Markets: A Brief Overview........................................................................................... 360
Investment Planning ................................................................................................................................. 371
Measuring Return and Risk....................................................................................................................... 380
Diversification: Return with Less Risk ..................................................................................................... 387
Chapter 13: Behavioral Finance and Market Behavior............................................. 393
Investor Behavior....................................................................................................................................... 394
Market Behavior ........................................................................................................................................ 403
Extreme Market Behavior ......................................................................................................................... 408
Behavioral Finance and Investment Strategies ...................................................................................... 414
iv
Chapter 14: The Practice of Investment....................................................................... 421
Investment Information............................................................................................................................ 422
Investing and Trading ............................................................................................................................... 431
Ethics and Regulation ................................................................................................................................ 437
Investing Internationally: Risks and Regulations................................................................................... 446
Chapter 15: Owning Stocks ............................................................................................. 453
Stocks and Stock Markets ......................................................................................................................... 455
Stock Value ................................................................................................................................................. 463
Common Measures of Value ..................................................................................................................... 468
Equity Strategies ........................................................................................................................................ 476
Chapter 16: Owning Bonds .............................................................................................. 481
Bonds and Bond Markets........................................................................................................................... 482
Bond Value.................................................................................................................................................. 491
Bond Strategies .......................................................................................................................................... 503
Chapter 17: Investing in Mutual Funds, Commodities, Real Estate, and
Collectibles ......................................................................................................................... 508
Mutual Funds.............................................................................................................................................. 509
Real Estate Investments ............................................................................................................................ 522
Commodities and Collectibles................................................................................................................... 527
Chapter 18: Career Planning .......................................................................................... 536
Choosing a Job ............................................................................................................................................ 538
Finding a Job ............................................................................................................................................... 547
Leaving a Job............................................................................................................................................... 562
v
About the Authors
Rachel S. Siegel, CFA
Rachel S. Siegel, chartered financial analyst (CFA), has

been a professor of finance, economics, and accounting
at Lyndon State College since 1990. She has also taught
as an adjunct faculty member at Trinity College
(Vermont), Granite State College (New Hampshire),
Springfield College (Massachusetts), the University of
Vermont, and in Tel Aviv, Israel, for Champlain College.
Siegel is a member of the Vermont CFA Society, the CFA Photograph by David G. Ballou.
Institute, and the Board of Scholars of the Ethan Allen
Institute, as well as a voting member of the National
Academy of Recording Arts and Sciences. She has served
as a consultant on investment strategy to the Vermont
Land Trust and to other private clients.
Siegel’s column “Follow the Money” has been a regular feature of the Northstar
Monthly since 2001.
Originally from Providence, Rhode Island, Siegel earned a BA in English literature

(1980) and an MBA (1989) from Yale University. She lives in Barnet, Vermont.
Carol Yacht, Business Educator and Author
Carol Yacht is a business educator and textbook author.

Yacht’s best-selling textbook, Computer Accounting with
Peachtree (McGraw-Hill/Irwin), is in its fourteenth
edition. She has also written textbooks for QuickBooks,
Microsoft Dynamics GP, Microsoft Office Accounting,
Excel, and Carol Yacht’s General Ledger.
Yacht’s writing career started in the classroom. To help her students learn new
business and technology concepts, Yacht created instructional material. Her first
book was published in 1979. Yacht is committed to teaching, learning, sharing, and
writing. She is a frequent presenter at conferences.
1
About the Authors
Yacht teaches Accounting Information Systems at the University of South Florida

Sarasota-Manatee, College of Business, Executive and Professional Education
Center. She has also taught on the faculties of California State University–Los
Angeles, West Los Angeles College, Yavapai College, and Beverly Hills High School.
She is also the Accounting Section Editor for the Business Education Forum, a
publication of the National Business Education Association; serves on the AAA
Commons Editorial Board; and is a member of the Microsoft Dynamics Academic
Advisory Council.
In 2005, Yacht received the Lifetime Achievement Award from the American
Accounting Association Two-Year College Section. She is also a recipient of the
Business Education Leadership Award from the State of California.
Yacht received her MA from California State University–Los Angeles, BS from the
University of New Mexico, and AS from Temple University.
Yacht is married to the artist Brice Wood. Her son, Matthew Lowenkron, is an
accountant, and her stepdaughter, Jessica Wood, is a writer.
2
Acknowledgments
I am very grateful to Jeff Shelstad, Mary Ellen Lepionka, Shannon Gattens, and the
staff at Unnamed Publisher. Friends and family have been more than patient
throughout; their faith has been unfailing and their support has been vital. I am
thankful for the inspiration of several great teachers, notably Stan Gartska, Stephen
A. Ross, Jon Ingersoll, and Barbara Stanhope. Most of all, I have been fortunate to
have been taught by hundreds of students, of all ages and stages, from whom I have
learned so much.
—Rachel S. Siegel
3
Dedications
This text is dedicated to my parents, Jason and Tovia Siegel.
4
Preface
This text has an attitude: that in addition to providing sources of practical
information, it should introduce you to a way of thinking about your personal
financial decisions. This should lead you to thinking harder and farther about the
larger and longer consequences of your decisions. Many of the more practical
aspects of personal finance will change over time, as practices, technologies,
intermediaries, customs, and laws change, but a fundamental awareness of ways to
think well about solving financial questions can always be useful. Some of the more
practical ideas may be obviously and immediately relevant—and some not—but
decision-making and research skills are lasting.
You may be enrolled in a traditional two- or four-year degree program or may just
be taking the course for personal growth. You may be of any age and may have
already done more or less academic and experiential learning. You may be a
business major, with some prerequisite knowledge of economics or level of
accounting or math skills, or you may be filling in an elective and have no such
skills. In fact, although they enhance personal finance decisions, such skills are not
necessary. Software, downloadable applications, and calculators perform ever more
sophisticated functions with ever more approachable interfaces. The emphasis in
this text is on understanding the fundamental relationships behind the math and
being able to use that understanding to make better decisions about your personal
finances.
Entire tomes, both academic texts and trade books, have been and will be written
about any of the subjects featured in each chapter of this text. The idea here is to
introduce you to the practical and conceptual framework for making personal
financial decisions in the larger context of your life, and in the even larger context
of your individual life as part of a greater economy of financial participants.
Structure
The text may be divided into five sections:
1. Learning Basic Skills, Knowledge, and Context (Chapter 1 "Personal

Financial Planning"–Chapter 6 "Taxes and Tax Planning")
2. Getting What You Want (Chapter 7 "Financial Management"–Chapter 9
"Buying a Home")
5
Preface
3. Protecting What You’ve Got (Chapter 10 "Personal Risk Management:

Insurance"–Chapter 11 "Personal Risk Management: Retirement and
Estate Planning")
4. Building Wealth (Chapter 12 "Investing"–Chapter 17 "Investing in
Mutual Funds, Commodities, Real Estate, and Collectibles")
5. How to Get Started (Chapter 18 "Career Planning")
This structure is based on the typical life cycle of personal financial decisions,
which in turn is based on the premise that in a market economy, an individual
participates by trading something of value: labor or capital. Most of us start with
nothing to trade but labor. We hope to sustain our desired lifestyle on the earnings
from labor and to gradually (or quickly) amass capital that will then provide
additional earnings.
Learning Basic Skills, Knowledge, and Context (Chapter 1 "Personal Financial

Planning"–Chapter 6 "Taxes and Tax Planning")
Chapter 1 "Personal Financial Planning" introduces four of its major themes:
• Financial decisions are individual-specific (Section 1.1 "Individual or

“Micro” Factors That Affect Financial Thinking").
• Financial decisions are economic decisions (Section 1.2 "Systemic or
“Macro” Factors That Affect Financial Thinking").
• Financial decision making is a continuous process (Section 1.3 "The
Planning Process").
• Professional advisors work for financial decision makers (Section 1.4
"Financial Planning Professionals").
These themes emphasize the idiosyncratic, systemic, and continuous nature of

personal finance, putting decisions within the larger contexts of an entire lifetime
and an economy.
Chapter 2 "Basic Ideas of Finance" introduces the basic financial and accounting
categories of revenues, expenses, assets, liabilities, and net worth as tools to
understand the relationships between them as a way, in turn, of organizing
financial thinking. It also introduces the concepts of opportunity costs and sunk
costs as implicit but critical considerations in financial thinking.
6
Preface
Chapter 3 "Financial Statements" continues with the discussion of organizing

financial data to help in decision making and introduces basic analytical tools that
can be used to clarify the situation portrayed in financial statements.
Chapter 4 "Evaluating Choices: Time, Risk, and Value" introduces the critical
relationships of time and risk to value. It demonstrates the math but focuses on the
role that those relationships play in financial thinking, especially in comparing and
evaluating choices in making financial decisions.
Chapter 5 "Financial Plans: Budgets" demonstrates how organized financial data

can be used to create a plan, monitor progress, and adjust goals.
Chapter 6 "Taxes and Tax Planning" discusses the role of taxation in personal
finance and its effects on earnings and on accumulating wealth. The chapter
emphasizes the types, purposes, and impacts of taxes; the organization of resources
for information; and the areas of controversy that lead to changes in the tax rules.
Getting What You Want (Chapter 7 "Financial Management"–Chapter 9

"Buying a Home")
Chapter 7 "Financial Management" focuses on financing consumption using current

earnings and/or credit, and financing longer-term assets with debt.
Chapter 8 "Consumer Strategies" discusses purchasing decisions, starting with

recurring consumption, and then goes into detail on the purchase of a car, a more
significant and longer-term purchase both in terms of its use and financing.
Chapter 9 "Buying a Home" applies the ideas developed in the previous chapter to
what, for most people, will be the major purchase: a home. The chapter discusses its
role both as a living expense and an investment, as well as the financing and
financial consequences of the purchase.
Protecting What You’ve Got (Chapter 10 "Personal Risk Management:

Insurance"–Chapter 11 "Personal Risk Management: Retirement and Estate
Planning")
7
Preface
Chapter 10 "Personal Risk Management: Insurance" introduces the idea of

incorporating risk management into financial planning. An awareness of the need
for risk management often comes with age and experience. This chapter focuses on
planning for the unexpected. It progresses from the more obvious risks to property
to the less obvious risks, such as the possible inability to earn due to temporary ill
health, permanent disability, or death.
Chapter 11 "Personal Risk Management: Retirement and Estate Planning" focuses

on planning for the expected: retirement, loss of income from wages, and the
subsequent distribution of assets after death. Retirement planning discusses ways
to develop alternative sources of income from capital that can eventually substitute
for wages. Estate planning also touches on the considerations and mechanics of
distributing accumulated wealth.
Building Wealth (Chapter 12 "Investing"–Chapter 17 "Investing in Mutual

Funds, Commodities, Real Estate, and Collectibles")
Chapter 12 "Investing" presents basic information about investment instruments

and markets and explains the classic relationships of risk and return developed in
modern portfolio theory.
Chapter 13 "Behavioral Finance and Market Behavior" then digresses from classical
theory to take a look at how both personal and market behavior can deviate from
the classic risk-return relationships and the consequences for personal financial
planning and thinking.
Chapter 14 "The Practice of Investment" looks at the mechanics of the investment

process, discussing issues of technology, the investor-broker relationship, and the
differences between domestic and international investing.
Chapter 15 "Owning Stocks", Chapter 16 "Owning Bonds", and Chapter 17

"Investing in Mutual Funds, Commodities, Real Estate, and Collectibles" look at
investments commonly made by individual investors and their use in and risks for
building wealth as part of a diverse investment strategy.
How to Get Started (Chapter 18 "Career Planning")
8
Preface
Chapter 18 "Career Planning" brings the planning process full circle with a
discussion on how to think about getting started, that is, deciding how to approach
the process of selling your labor. The chapter introduces the idea of selling labor as
a consumable commodity to employers in the labor market and explores how to
search and apply for a job in light of its strategic as well as immediate potential.
9
Chapter 1
Personal Financial Planning
Introduction
Bryon and Tomika are just one semester shy of graduating from a state college.
Bryon is getting a degree in protective services and is thinking of going for
certification as a fire protection engineer, which would cost an additional $4,500.
With his protective services degree many other fields will be open to him as
well—from first responder to game warden or correctional officer. Bryon will have
to specialize immediately and wants a job in his state that comes with some
occupational safety and a lot of job security.
Tomika is getting a Bachelor of Science degree in medical technology and hopes to

parlay that into a job as a lab technician. She has interviews lined up at a nearby
regional hospital and a local pharmaceutical firm. She hopes she gets the hospital
job because it pays a little better and offers additional training on site. Both Bryon
and Tomika will need additional training to have the jobs they want, and they are
already in debt for their educations.
Tomika qualified for a Stafford loan, and the federal government subsidizes her
loan by paying the interest on it until six months after she graduates. She will owe
about $40,000 of principal plus interest at a fixed annual rate of 6.8 percent. Tomika
plans to start working immediately on graduation and to take classes on the job or
at night for as long as it takes to get the extra certification she needs. Unsubsidized,
the extra training would cost about $3,500. She presently earns about $5,000 a year
working weekends as a home health aide and could easily double that after she
graduates. Tomika also qualified for a Pell grant of around $5,000 each year she was
a full-time student, which has paid for her rooms in an off-campus student co-op
housing unit. Bryon also lives there, and that’s how they met.
Bryon would like to get to a point in his life where he can propose marriage to
Tomika and looks forward to being a family man one day. He was awarded a service
scholarship from his hometown and received windfall money from his
grandmother’s estate after she died in his sophomore year. He also borrowed
$30,000 for five years at only 2.25 percent interest from his local bank through a
family circle savings plan. He has been attending classes part-time year-round so he
can work to earn money for college and living expenses. He earns about $19,000 a
10
Chapter 1 Personal Financial Planning
year working for catering services. Bryon feels very strongly about repaying his
relatives who have helped finance his education and also is willing to help Tomika
pay off her Stafford loan after they marry.
Tomika has $3,000 in U.S. Treasury Series EE savings bonds, which mature in two
years, and has managed to put aside $600 in a savings account earmarked for
clothes and gifts. Bryon has sunk all his savings into tuition and books, and his only
other asset is his trusty old pickup truck, which has no liens and a trade-in value of
$3,900. For both Tomika and Bryon, having reliable transportation to their jobs is a
concern. Tomika hopes to continue using public transportation to get to a new job
after graduation. Both Bryon and Tomika are smart enough about money to have
avoided getting into credit card debt. Each keeps only one major credit card and a
debit card and with rare exceptions pays statements in full each month.
Bryon and Tomika will have to find new housing after they graduate. They could
look for another cooperative housing opportunity or rent apartments, or they could
get married now instead of waiting. Bryon also has a rent-free option of moving in
temporarily with his brother. Tomika feels very strongly about saving money to buy
a home and wants to wait until her career is well established before having a child.
Tomika is concerned about getting good job benefits, especially medical insurance
and family leave. Although still young, Bryon is concerned about being able to
retire, the sooner the better, but he has no idea how that would be possible. He
thinks he would enjoy running his own catering firm as a retirement business some
day.
Tomika’s starting salary as a lab technician will be about $30,000, and as a fire
protection engineer, Bryon would have a starting salary of about $38,000. Both have
the potential to double their salaries after fifteen years on the job, but they are
worried about the economy. Their graduations are coinciding with a downturn.
Aside from Tomika’s savings bonds, she and Bryon are not in the investment
market, although as soon as he can Bryon wants to invest in a diversified portfolio
of money market funds that include corporate stocks and municipal bonds.
Nevertheless, the state of the economy affects their situation. Money is tight and
loans are hard to get, jobs are scarce and highly competitive, purchasing power and
interest rates are rising, and pension plans and retirement funds are at risk of
losing value. It’s uncertain how long it will be before the trend reverses, so for the
short term, they need to play it safe. What if they can’t land the jobs they’re
preparing for?
Tomika and Bryon certainly have a lot of decisions to make, and some of those
decisions have high-stakes consequences for their lives. In making those decisions,
they will have to answer some questions, such as the following:
11
1. What individual or personal factors will affect Tomika’s and Bryon’s

financial thinking and decision making?
2. What are Bryon’s best options for job specializations in protective
services? What are Tomika’s best options for job placement in the field
of medical technology?
3. When should Bryon and Tomika invest in the additional job training
each will need, and how can they finance that training?
4. How will Tomika pay off her college loan, and how much will it cost?
How soon can she get out of debt?
5. How will Bryon repay his loan reflecting his family’s investment in his
education?
6. What are Tomika’s short-term and long-term goals? What are Bryon’s?
If they marry, how well will their goals mesh or need to adjust?
7. What should they do about medical insurance and retirement needs?
8. What should they do about saving and investing?
9. What should they do about getting married and starting a family?
10. What should they do about buying a home and a car?
11. What is Bryon’s present and projected income from all sources? What
is Tomika’s?
12. What is the tax liability on their present incomes as singles? What
would their tax liability be on their future incomes if they filed jointly
as a married couple?
13. What budget categories would you create for Tomika’s and Bryon’s
expenses and expenditures over time?
14. How could Tomika and Bryon adjust their budgets to meet their short-
term and long-term goals?
15. On the basis of your analysis and investigations, what five-year
financial plan would you develop for Tomika and Bryon?
16. How will larger economic factors affect the decisions Bryon and
Tomika make and the outcomes of those decisions?
You will make financial decisions all your life. Sometimes you can see those
decisions coming and plan deliberately; sometimes, well, stuff happens, and you are
faced with a more sudden decision. Personal financial planning is about making
deliberate decisions that allow you to get closer to your goals or sudden decisions
that allow you to stay on track, even when things take an unexpected turn.
The idea of personal financial planning is really no different from the idea of
planning most anything: you figure out where you’d like to be, where you are, and
how to go from here to there. The process is complicated by the number of factors
to consider, by their complex relationships to each other, and by the profound
nature of these decisions, because how you finance your life will, to a large extent,
determine the life that you live. The process is also, often enormously, complicated
12
by risk: you are often making decisions with plenty of information, but little
certainty or even predictability.
Personal financial planning is a lifelong process. Your time horizon is as long as can
be—until the very end of your life—and during that time your circumstances will
change in predictable and unpredictable ways. A financial plan has to be re-
evaluated, adjusted, and re-adjusted. It has to be flexible enough to be responsive to
unanticipated needs and desires, robust enough to advance toward goals, and all
the while be able to protect from unimagined risks.
One of the most critical resources in the planning process is information. We live in
a world awash in information—and no shortage of advice—but to use that
information well you have to understand what it is telling you, why it matters,
where it comes from, and how to use it in the planning process. You need to be able
to put that information in context, before you can use it wisely. That context
includes factors in your individual situation that affect your financial thinking, and
factors in the wider economy that affect your financial decision making.
13
1.1 Individual or “Micro” Factors That Affect Financial Thinking
LEARNING OBJECTIVES
1. List individual factors that strongly influence financial thinking.

2. Discuss how income, income needs, risk tolerance, and wealth are
affected by individual factors.
3. Explain how life stages affect financial decision making.
4. Summarize the basis of sound financial planning.
The circumstances or characteristics of your life influence your financial concerns

and plans. What you want and need—and how and to what extent you want to
protect the satisfaction of your wants and needs—all depend on how you live and
how you’d like to live in the future. While everyone is different, there are common
circumstances of life that affect personal financial concerns and thus affect
everyone’s financial planning. Factors that affect personal financial concerns are
family structure, health, career choices, and age.
Family Structure
Marital status and dependents, such as children, parents, or siblings, determine

whether you are planning only for yourself or for others as well. If you have a
spouse or dependents, you have a financial responsibility to someone else, and that
includes a responsibility to include them in your financial thinking. You may expect
the dependence of a family member to end at some point, as with children or
elderly parents, or you may have lifelong responsibilities to and for another person.
Partners and dependents affect your financial planning as you seek to provide for
them, such as paying for children’s education. Parents typically want to protect or
improve the quality of life for their children and may choose to limit their own
fulfillment to achieve that end.
Providing for others increases income needs. Being responsible for others also
affects your attitudes toward and tolerance of risk. Typically, both the willingness
and ability to assume risk diminishes with dependents, and a desire for more
financial protection grows. People often seek protection for their income or assets
even past their own lifetimes to ensure the continued well-being of partners and
dependents. An example is a life insurance policy naming a spouse or dependents as
beneficiaries.
14
Health
Your health is another defining circumstance that will affect your expected income
needs and risk tolerance and thus your personal financial planning. Personal
financial planning should include some protection against the risk of chronic
illness, accident, or long-term disability and some provision for short-term events,
such as pregnancy and birth. If your health limits your earnings or ability to work
or adds significantly to your expenditures, your income needs may increase. The
need to protect yourself against further limitations or increased costs may also
increase. At the same time your tolerance for risk may decrease, further affecting
your financial decisions.
Career Choice
Your career choices affect your financial planning, especially through educational
requirements, income potential, and characteristics of the occupation or profession
you choose. Careers have different hours, pay, benefits, risk factors, and patterns of
advancement over time. Thus, your financial planning will reflect the realities of
being a postal worker, professional athlete, commissioned sales representative,
corporate lawyer, freelance photographer, librarian, building contractor, tax
preparer, professor, Web site designer, and so on. For example, the careers of most
athletes end before middle age, have higher risk of injury, and command steady,
higher-than-average incomes, while the careers of most sales representatives last
longer with greater risk of unpredictable income fluctuations. Figure 1.1 "Median
Salary Comparisons by Profession" compares the median salaries of certain careers.
1.1 Individual or “Micro” Factors That Affect Financial Thinking 15

Figure 1.1 Median Salary Comparisons by ProfessionBased on data from http://www.careeroverview.com/

salary-benefits.html (accessed November 21, 2009).
Most people begin their independent financial lives by selling their labor to create
an income by working. Over time they may choose to change careers, develop
additional sources of concurrent income, move between employment and self-
employment, or become unemployed or reemployed. Along with career choices, all
these changes affect personal financial management and planning.
Age
Needs, desires, values, and priorities all change over a lifetime, and financial
concerns change accordingly. Ideally, personal finance is a process of management
1. Periods of a person’s life based and planning that anticipates or keeps abreast with changes. Although everyone is
on age and personal
circumstances that reflect different, some financial concerns are common to or typical of the different stages
different needs, goals, and of adult life. Analysis of life stages1 is part of financial planning.
financial capabilities.
2. Resources that can be used to At the beginning of your adult life, you are more likely to have no dependents, little
create future economic benefit,
if any accumulated wealth, and few assets2. (Assets are resources that can be used
such as increasing income,
decreasing expenses, or storing to create income, decrease expenses, or store wealth as an investment.) As a young
wealth as an investment. adult you also are likely to have comparatively small income needs, especially if you

are providing only for yourself. Your employment income is probably your primary
or sole source of income. Having no one and almost nothing to protect, your
willingness to assume risk is usually high. At this point in your life, you are focused
on developing your career and increasing your earned income. Any investments
you may have are geared toward growth.
As your career progresses, income increases but so does spending. Lifestyle

expectations increase. If you now have a spouse and dependents and elderly parents
to look after, you have additional needs to manage. In middle adulthood you may
also be acquiring more assets, such as a house, a retirement account, or an
inheritance.
As income, spending, and asset base grow, ability to

assume risk grows, but willingness to do so typically Figure 1.2
decreases. Now you have things that need protection:
dependents and assets. As you age, you realize that you
require more protection. You may want to stop working
one day, or you may suffer a decline in health. As an
older adult you may want to create alternative sources
of income, perhaps a retirement fund, as insurance
against a loss of employment or income. Figure 1.3
"Financial Decisions Related to Life Stages" suggests the
effects of life stages on financial decision making.
© 2010 Jupiterimages
Corporation

Figure 1.3 Financial Decisions Related to Life Stages
Early and middle adulthoods are periods of building up: building a family, building a
career, increasing earned income, and accumulating assets. Spending needs
increase, but so do investments and alternative sources of income.
Later adulthood is a period of spending down. There is less reliance on earned

income and more on the accumulated wealth of assets and investments. You are
likely to be without dependents, as your children have grown up or your parents
passed on, and so without the responsibility of providing for them, your expenses
are lower. You are likely to have more leisure time, especially after retirement.
Without dependents, spending needs decrease. On the other hand, you may feel free
to finally indulge in those things that you’ve “always wanted.” There are no longer
dependents to protect, but assets demand even more protection as, without
employment, they are your only source of income. Typically, your ability to assume
risk is high because of your accumulated assets, but your willingness to assume risk
is low, as you are now dependent on those assets for income. As a result, risk
tolerance decreases: you are less concerned with increasing wealth than you are
with protecting it.
Effective financial planning depends largely on an awareness of how your current

and future stages in life may influence your financial decisions.

KEY TAKEAWAYS
• Personal circumstances that influence financial thinking include family

structure, health, career choice, and age.
• Family structure and health affect income needs and risk tolerance.
• Career choice affects income and wealth or asset accumulation.
• Age and stage of life affect sources of income, asset accumulation,
spending needs, and risk tolerance.
• Sound personal financial planning is based on a thorough understanding
of your personal circumstances and goals.
EXERCISES
1. Use Flat World’s My Notes feature to start keeping a written record of

observations and insights about your financial thinking and behavior.
You may be surprised at what you discover. In the process, consider how
information in this text specifically relates to your observations and
insights. Reading this chapter, for example, identify and describe your
current life stage. How does your current age or life stage affect your
financial thinking and behavior? To what extent and in what ways does
your financial thinking anticipate your next stage of life? What financial
goals are you aware of that you have set? How are your current
experiences informing your financial planning for the future?
2. Continue your personal financial journal by describing how other micro
factors, such as your present family structure, health, career choices,
and other individual factors, are affecting your financial planning. The
My Notes feature allows you to share given entries or to keep them
private. You can save your notes. You also can highlight and right click
on your notes to copy and paste them into a word document on your
computer.
3. Find the age range for your stage of life and read the advice at
http://financialplan.about.com/od/moneybyageorlifestage/
Money_and_Personal_Finance_by_Age_Life_Stage.htm. According to the
articles on this page, what should be your top priorities in financial
planning right now? Read the articles on the next life stage. How are
your financial planning priorities likely to change?

1.2 Systemic or “Macro” Factors That Affect Financial Thinking
LEARNING OBJECTIVES
1. Identify the systemic or macro factors that affect personal financial

planning.
2. Describe the impact of inflation or deflation on disposable income.
3. Describe the effect of rising unemployment on disposable income.
4. Explain how economic indicators can have an impact on personal
finances.
Financial planning has to take into account conditions in the wider economy and in
the markets that make up the economy. The labor market3, for example, is where
labor is traded through hiring or employment. Workers compete for jobs and
employers compete for workers. In the capital market4, capital (cash or assets) is
traded, most commonly in the form of stocks and bonds (along with other ways to
package capital). In the credit market5, a part of the capital market, capital is
3. Where labor is traded through
loaned and borrowed rather than bought and sold. These and other markets exist in
hiring or employment and
price is determined by the a dynamic economic environment, and those environmental realities are part of
interaction of employers and sound financial planning.
employees.
4. A market where long-term In the long term, history has proven that an economy can grow over time, that
liquidity is traded.
investments can earn returns, and that the value of currency can remain relatively
5. A part of the capital market stable. In the short term, however, that is not continuously true. Contrary or
where capital is lent and unsettled periods can upset financial plans, especially if they last long enough or
borrowed through the trading
of debt securities such as
happen at just the wrong time in your life. Understanding large-scale economic
bonds. patterns and factors that indicate the health of an economy can help you make
better financial decisions. These systemic factors include, for example, business
6. The total value of all final
goods and services produced in
cycles and employment rates.
a year in a nation’s economy. It
is used as a fundamental
measure of an economy’s
Business Cycles
growth based on its ability to
use resources productively and An economy tends to be productive enough to provide for the wants of its members.
provide for its members.
Normally, economic output increases as population increases or as people’s
7. A period of economic expectations grow. An economy’s output or productivity is measured by its gross
contraction lasting at least six domestic product6 or GDP, the value of what is produced in a period. When the
consecutive months or two
consecutive quarters. GDP is increasing, the economy is in an expansion, and when it is decreasing, the
economy is in a contraction. An economy that contracts for half a year is said to be
8. A prolonged and severe in recession7; a prolonged recession is a depression8. The GDP is a closely watched
recession.
20
barometer of the economy (see Figure 1.4 "GDP Percent Change (Based on Current
Dollars)").
Figure 1.4 GDP Percent Change (Based on Current Dollars)Based on data from the Bureau of Economic Analysis,
U.S. Department of Commerce, http://www.bea.gov/national/ (accessed November 21, 2009).
Over time, the economy tends to be cyclical, usually expanding but sometimes
contracting. This is called the business cycle9. Periods of contraction are generally
seen as market corrections, or the market regaining its equilibrium, after periods of
growth. Growth is never perfectly smooth, so sometimes certain markets become
unbalanced and need to correct themselves. Over time, the periods of contraction
seem to have become less frequent, as you can see in Figure 1.4 "GDP Percent
Change (Based on Current Dollars)". The business cycles still occur nevertheless.
There are many metaphors to describe the cyclical nature of market economies:
“peaks and troughs,” “boom and bust,” “growth and contraction,” “expansion and
correction,” and so on. While each cycle is born in a unique combination of
circumstances, cycles occur because things change and upset economic equilibrium.
That is, events change the balance between supply and demand in the economy
overall. Sometimes demand grows too fast and supply can’t keep up, and sometimes
supply grows too fast for demand. There are many reasons that this could happen,
but whatever the reasons, buyers and sellers react to this imbalance, which then
creates a change.
9. Recurring periods of economy- Employment Rate

wide expansion, when the
economy is growing, and
contraction, when the An economy produces not just goods and services to satisfy its members but also
economy is shrinking. Cycles jobs, because most people participate in the market economy by trading their labor,
are often measured by the
and most rely on wages as their primary source of income. The economy therefore
increase or decrease in the
GDP. must provide opportunity to earn wages so more people can participate in the
1.2 Systemic or “Macro” Factors That Affect Financial Thinking 21

economy through the market. Otherwise, more people must be provided for in some
other way, such as a private or public subsidy (charity or welfare).
The unemployment rate10 is a measure of an

economy’s shortcomings, because it shows the Figure 1.5
proportion of people who want to work but don’t
because the economy cannot provide them jobs. There
is always some so-called natural rate of unemployment
as people move in and out of the workforce as the
circumstances of their lives change—for example, as
they retrain for a new career or take time out for family.
But natural unemployment should be consistently low
and not affect the productivity of the economy.
Corporation
Unemployment also shows that the economy is not
efficient, because it is not able to put all its productive
human resources to work.
The employment rate11, or the participation rate of the labor force, shows how
successful an economy is at creating opportunities to sell labor and efficiently using
its human resources. A healthy market economy uses its labor productively, is
productive, and provides employment opportunities as well as consumer
satisfaction through its markets. Figure 1.6 "Cyclical Economic Effects" shows the
relationship between GDP and unemployment and each stage of the business cycle.
Figure 1.6 Cyclical Economic Effects
10. A measure of the percentage of

people in the labor force who
are unemployed, that is, those
who would like to be working
but cannot find a suitable job. At either end of this scale of growth, the economy is in an unsustainable position:
either growing too fast, with too much demand for labor, or shrinking, with too
11. A measure of the rate of labor little demand for labor.
force participation, or the
percentage of the labor force
that is employed, that is,
people who want to work and
If there is too much demand for labor—more jobs than workers to fill them—then
are working. wages will rise, pushing up the cost of everything and causing prices to rise. Prices

usually rise faster than wages, for many reasons, which would discourage
consumption that would eventually discourage production and cause the economy
to slow down from its “boom” condition into a more manageable rate of growth.
If there is too little demand for labor—more workers than jobs—then wages will fall
or, more typically, there will be people without jobs, or unemployment. If wages
become low enough, employers theoretically will be encouraged to hire more labor,
which would bring employment levels back up. However, it doesn’t always work
that way, because people have job mobility—they are willing and able to move
between economies to seek employment.
If unemployment is high and prolonged, then too many people are without wages
for too long, and they are not able to participate in the economy because they have
nothing to trade. In that case, the market economy is just not working for too many
people, and they will eventually demand a change (which is how most revolutions
have started).
Other Indicators of Economic Health
Other economic indicators give us clues as to how “successful” our economy is, how
well it is growing, or how well positioned it is for future growth. These indicators
include statistics, such as the number of houses being built or existing home sales,
orders for durable goods (e.g., appliances and automobiles), consumer confidence,
producer prices, and so on. However, GDP growth and unemployment are the two
most closely watched indicators, because they get at the heart of what our economy
is supposed to accomplish: to provide diverse opportunities for the most people to
participate in the economy, to create jobs, and to satisfy the consumption needs of
the most people by enabling them to get what they want.
An expanding and healthy economy will offer more choices to participants: more
choices for trading labor and for trading capital. It offers more opportunities to
earn a return or an income and therefore also offers more diversification and less
risk.
Naturally, everyone would rather operate in a healthier economy at all times, but
this is not always possible. Financial planning must include planning for the risk
that economic factors will affect financial realities. A recession may increase
unemployment, lowering the return on labor—wages—or making it harder to
anticipate an increase in income. Wage income could be lost altogether. Such
temporary involuntary loss of wage income probably will happen to you during
your lifetime, as you inevitably will endure economic cycles.

A hedge against lost wages is investment to create other forms of income. In a

period of economic contraction, however, the usefulness of capital, and thus its
value, may decline as well. Some businesses and industries are considered immune
to economic cycles (e.g., public education and health care), but overall, investment
returns may suffer. Thus, during your lifetime business cycles will likely affect your
participation in the capital markets as well.
Currency Value
Stable currency value is another important indicator of a healthy economy and a

critical element in financial planning. Like anything else, the value of a currency is
based on its usefulness. We use currency as a medium of exchange, so the value of a
currency is based on how it can be used in trade, which in turn is based on what is
produced in the economy. If an economy produces little that anyone wants, then its
currency has little value relative to other currencies, because there is little use for it
in trade. So a currency’s value is an indicator of how productive an economy is.
A currency’s usefulness is based on what it can buy, or its purchasing power12. The
more a currency can buy, the more useful and valuable it is. When prices rise or
when things cost more, purchasing power decreases; the currency buys less and its
value decreases.
When the value of a currency decreases, an economy has inflation13. Its currency
has less value because it is less useful; that is, less can be bought with it. Prices are
rising. It takes more units of currency to buy the same amount of goods. When the
value of a currency increases, on the other hand, an economy has deflation14.
12. A currency’s usefulness and
Prices are falling; the currency is worth more and buys more.
thus its value as measured by
how much it can buy, that is,
the quantity of goods and
services that can be purchased For example, say you can buy five video games for $20. Each game is worth $4, or
with one unit of currency. each dollar buys ¼ of a game. Then we have inflation, and prices—including the
price of video games—rise. A year later you want to buy games, but now your $20
13. Period characterized by rising
prices, declining purchasing only buys two games. Each one costs $10, or each dollar only buys one-tenth of a
power, and lower currency game. Rising prices have eroded the purchasing power of your dollars.
values (one unit of currency is
worth less because it buys a
smaller quantity of goods and If there is deflation, prices fall, so maybe a year later you could buy ten video games
services). with your same $20. Now each game costs only $2, and each dollar buys half a game.
14. Period characterized by falling The same amount of currency buys more games: its purchasing power has
prices, increasing purchasing increased, as has its usefulness and its value (Figure 1.7 "Dynamics of Currency
power, and higher currency Value").
values (one unit of currency is
worth more because it buys a
greater quantity of goods and
services).

Figure 1.7 Dynamics of Currency Value
Inflation is most commonly measured by the consumer

price index15 (CPI), an index created and tracked by the Figure 1.8
federal government. It measures the average
nationwide prices of a “basket” of goods and services
purchased by the average consumer. It is an accepted
way of tracking rising or falling price levels, indicative
of inflation or deflation. Figure 1.9 "Inflation,
1979–2008" shows the percent change in the consumer
price index as a measure of inflation during the period
from 1979 to 2008. © 2010 Jupiterimages
Corporation
Figure 1.9 Inflation, 1979–2008Based on data from the Bureau of Labor

Statistics, U.S. Department of Labor, http://www.bls.gov (accessed
November 21, 2009).
15. A measure of inflation or

deflation based on a national
average of prices for a “basket”
of common goods and services
purchased by the average
consumer.

Currency instabilities can also affect investment values, because the dollars that
investments return don’t have the same value as the dollars that the investment
was expected to return. Say you lend $100 to your sister, who is supposed to pay
you back one year from now. There is inflation, so over the next year, the value of
the dollar decreases (it buys less as prices rise). Your sister does indeed pay you
back on time, but now the $100 that she gives back to you is worth less (because it
buys less) than the $100 you gave her. Your investment, although nominally
returned, has lost value: you have your $100 back, but you can’t do as much with it;
it is less useful.
If the value of currency—the units in which wealth is measured and stored—is

unstable, then investment returns are harder to predict. In those circumstances,
investment involves more risk. Both inflation and deflation are currency
instabilities that are troublesome for an economy and also for the financial
planning process. An unstable currency affects the value or purchasing power of
income. Price changes affect consumption decisions, and changes in currency value
affect investing decisions.
It is human nature to assume that things will stay the same, but financial planning
must include the assumption that over a lifetime you will encounter and endure
economic cycles. You should try to anticipate the risks of an economic downturn
and the possible loss of wage income and/or investment income. At the same time,
you should not assume or rely on the windfalls of an economic expansion.

KEY TAKEAWAYS
• Business cycles include periods of expansion and contraction (including

recessions), as measured by the economy’s productivity (gross domestic
product).
• An economy is in an unsustainable situation when it grows too fast or
too slowly, as each situation causes too much stress in the economy’s
markets.
• In addition to GDP, measures of the health of an economy include
◦ the rates of employment and unemployment,

◦ the value of currency (the consumer price index).
• Financial planning should take into account the fact that periods of
inflation or deflation change the value of currency, affecting purchasing
power and investment values.
• Thus, personal financial planning should take into account
◦ business cycles,
◦ changes in the economy’s productivity,
◦ changes in the currency value,
◦ changes in other economic indicators.

EXERCISES
1. Go to http://www.nber.org/cycles.html to see a chart published by the

National Bureau of Economic Research. The chart shows business cycles
in the United States and their durations between 1854 and 2001. What
patterns and trends do you see in these historical data? Which years saw
the longest recessions? How can you tell that the U.S. economy has
tended to become more stable over the decades?
2. Record in your personal financial journal or in My Notes the
macroeconomic factors that are influencing your financial thinking and
behavior today. What are some specific examples? How have large-scale
economic changes or cycles, such as the economic recession of
2008–2009, affected your financial planning and decision making?
3. How does the health of the economy affect your financial health? How
healthy is the U.S. economy right now? On what measures do you base
your judgments? How will your appreciation of the big picture help you
in planning for your future?
4. How do business cycles and the health of the economy affect the value of
your labor? In terms of supply and demand, what are the optimal
conditions in which to sell your labor? How might further education
increase your mobility in the labor market (the value of your labor)?
5. Brainstorm with others taking this course on effective personal

financial strategies for
a. protecting against recession,

b. hedging against inflation,
c. mitigating the effects of deflation,
d. taking realistic advantage of periods of expansion.

1.3 The Planning Process
LEARNING OBJECTIVES
1. Trace the steps of the financial planning process and explain why that
process needs to be repeated over time.
2. Characterize effective goals and differentiate goals in terms of timing.
3. Explain and illustrate the relationships among costs, benefits, and risks.
4. Analyze cases of financial decision making by applying the planning
process.
A financial planning process16 involves figuring out where you’d like to be, where
you are, and how to go from here to there. More formally, a financial planning
process means the following:
• Defining goals
• Assessing the current situation
• Identifying choices
• Evaluating choices
• Choosing
• Assessing the resulting situation
• Redefining goals
• Identifying new choices
• Evaluating new choices
• Choosing
• Assessing the resulting situation over and over again
Personal circumstances change, and the economy changes, so your plans must be
flexible enough to adapt to those changes, yet be steady enough to eventually
achieve long-term goals. You must be constantly alert to those changes but “have a
strong foundation when the winds of changes shift.”“Forever Young,” music and
lyrics by Bob Dylan.
Defining Goals
16. A recursive process of defining
goals, assessing situations, Figuring out where you want to go is a process of defining goals. You have shorter-
identifying and evaluating
term (1–2 years), intermediate (2–10 years), and longer-term goals that are quite
choices, making choices and
assessing the results, realistic and goals that are more wishful. Setting goals is a skill that usually
redefining goals, and so on. improves with experience. According to a popular model, to be truly useful goals
29
must be Specific, Measurable, Attainable, Realistic, and Timely (S.M.A.R.T.). Goals

change over time, and certainly over a lifetime. Whatever your goals, however, life
is complicated and risky, and having a plan and a method to reach your goals
increases the odds of doing so.
For example, after graduating from college, Alice has an immediate focus on
earning income to provide for living expenses and debt (student loan) obligations.
Within the next decade, she foresees having a family; if so, she will want to
purchase a house and perhaps start saving for her children’s educations. Her
income will have to provide for her increased expenses and also generate a surplus
that can be saved to accumulate these assets.
In the long term, she will want to be able to retire and derive all her income from
her accumulated assets, and perhaps travel around the world in a sailboat. She will
have to have accumulated enough assets to provide for her retirement income and
for the travel. Figure 1.10 "Timing, Goals, and Income" shows the relationship
between timing, goals, and sources of income.
Figure 1.10 Timing, Goals, and Income
Alice’s income will be used to meet her goals, so it’s important for her to
understand where her income will be coming from and how it will help in achieving
her goals. She needs to assess her current situation.
1.3 The Planning Process 30

Assessing the Current Situation
Figuring out where you are or assessing the current situation involves
understanding what your present situation is and the choices that it creates. There
may be many choices, but you want to identify those that will be most useful in
reaching your goals.
Assessing the current situation is a matter of organizing personal financial

information into summaries that can clearly show different and important aspects
of financial life—your assets, debts, incomes, and expenses. These numbers are
expressed in financial statements—in an income statement, balance sheet, and cash
flow statement (topics discussed in Chapter 3 "Financial Statements"). Businesses
also use these three types of statements in their financial planning.
For now, we can assess Alice’s simple situation by identifying her assets and debts
and by listing her annual incomes and expenses. That will show if she can expect a
budget surplus or deficit, but more important, it will show how possible her goals
are and whether she is making progress toward them. Even a ballpark assessment of
the current situation can be illuminating.
Alice’s assets may be a car worth about $5,000 and a savings account with a balance
of $250. Debts include a student loan with a balance of $53,000 and a car loan with a
balance of $2,700; these are shown in Figure 1.11 "Alice’s Financial Situation".
Figure 1.11 Alice’s Financial Situation

Her annual disposable income (after-tax income or take-home pay) may be $35,720,
and annual expenses are expected to be $10,800 for rent and $14,400 for living
expenses—food, gas, entertainment, clothing, and so on. Her annual loan payments
are $2,400 for the car loan and $7,720 for the student loan, as shown in Figure 1.12
"Alice’s Income and Expenses".
Figure 1.12 Alice’s Income and Expenses
Alice will have an annual budget surplus of just $400 (income = $35,720 − $35,320
[total expenses + loan repayments]). She will be achieving her short-term goal of
reducing debt, but with a small annual budget surplus, it will be difficult for her to
begin to achieve her goal of accumulating assets.
To reach that intermediate goal, she will have to increase income or decrease
expenses to create more of an annual surplus. When her car loan is paid off next
year, she hopes to buy another car, but she will have at most only $650 (250 + 400) in
savings for a down payment for the car, and that assumes she can save all her
surplus. When her student loans are paid off in about five years, she will no longer
have student loan payments, and that will increase her surplus significantly (by
$7,720 per year) and allow her to put that money toward asset accumulation.
Alice’s long-term goals also depend on her ability to accumulate productive assets,
as she wants to be able to quit working and live on the income from her assets in
retirement. Alice is making progress toward meeting her short-term goals of

reducing debt, which she must do before being able to work toward her
intermediate and long-term goals. Until she reduces her debt, which would reduce
her expenses and increase her income, she will not make progress toward her
intermediate and long-term goals.
Assessing her current situation allows Alice to see that she has to delay
accumulating assets until she can reduce expenses by reducing debt (and thus her
student loan payments). She is now reducing debt, and as she continues to do so,
her financial situation will begin to look different, and new choices will be available
to her.
Alice learned about her current situation from two simple lists: one of her assets
and debts and the other of her income and expenses. Even in this simple example it
is clear that the process of articulating the current situation can put information
into a very useful context. It can reveal the critical paths to achieving goals.
Evaluating Alternatives and Making Choices
Figuring out how to go from here to there is a process of identifying immediate

choices and longer-term strategies or series of choices. To do this, you have to be
realistic and yet imaginative about your current situation to see the choices it
presents and the future choices that current choices may create. The characteristics
of your living situation—family structure, age, career choice, health—and the larger
context of the economic environment will affect or define the relative value of your
choices.
After you have identified alternatives, you evaluate each one. The obvious things to
look for and assess are its costs and benefits, but you also want to think about its
risks, where it will leave you, and how well positioned it will leave you to make the
next decision. You want to have as many choices as you can at any point in the
process, and you want your choices to be well diversified. That way, you can choose
with an understanding of how this choice will affect the next choices and the next.
The further along in the process you can think, the better you can plan.
In her current situation, Alice is reducing debt, so one choice would be to continue.
She could begin to accumulate assets sooner, and thus perhaps more of them, if she
could reduce expenses to create more of a budget surplus. Alice looks over her
expenses and decides she really can’t cut them back much. She decides that the
alternative of reducing expenses is not feasible. She could increase income,
however. She has two choices: work a second job or go to Las Vegas to play poker.

Alice could work a second, part-time job that would increase her after-tax income
but leave her more tired and with less time for other interests. The economy is in a
bit of a slump too—unemployment is up a bit—so her second job probably wouldn’t
pay much. She could go to Vegas and win big, with the cost of the trip as her only
expense. To evaluate her alternatives, Alice needs to calculate the benefits and costs
of each (Figure 1.13 "Alice’s Choices: Benefits and Costs").
Figure 1.13 Alice’s Choices: Benefits and Costs
Laying out Alice’s choices in this way shows their

consequences more clearly. The alternative with the Figure 1.14
biggest benefit is the trip to Vegas, but that also has the
biggest cost because it has the biggest risk: if she loses,
she could have even more debt. That would put her
further from her goal of beginning to accumulate assets,
which would have to be postponed until she could
eliminate that new debt as well as her existing debt.
Thus, she would have to increase her income and © 2010 Jupiterimages
Corporation
decrease her expenses. Simply continuing as she does
now would no longer be an option because the new debt
increases her expenses and creates a budget deficit. Her
only remaining alternative to increase income would be
to take the second job that she had initially rejected because of its implicit cost. She
would probably have to reduce expenses as well, an idea she initially rejected as not

even being a reasonable choice. Thus, the risk of the Vegas option is that it could
force her to “choose” alternatives that she had initially rejected as too costly.
Figure 1.15 Considering Risk in Alice’s Choice
The Vegas option becomes least desirable when its risk is included in the
calculations of its costs, especially as they compare with its benefits.
Its obvious risk is that Alice will lose wealth, but its even costlier risk is that it will
limit her future choices. Without including risk as a cost, the Vegas option looks
attractive, which is, of course, why Vegas exists. But when risk is included, and
when the decision involves thinking strategically not only about immediate
consequences but also about the choices it will preserve or eliminate, that option
can be seen in a very different light (Figure 1.16 "Alice’s Choices: Benefits and More
Costs").

Figure 1.16 Alice’s Choices: Benefits and More Costs
You may sometimes choose an alternative with less apparent benefit than another
but also with less risk. You may sometimes choose an alternative that provides less
immediate benefit but more choices later. Risk itself is a cost, and choice a benefit,
and they should be included in your assessment.

KEY TAKEAWAYS
• Financial planning is a recursive process that involves
◦ defining goals,
◦ assessing the current situation,
◦ identifying choices,
◦ evaluating choices,
◦ choosing.
• Choosing further involves assessing the resulting situation, redefining
goals, identifying new choices, evaluating new choices, and so on.
• Goals are shaped by current and expected circumstances, family
structure, career, health, and larger economic forces.
• Depending on the factors shaping them, goals are short-term,
intermediate, and long-term.
• Choices will allow faster or slower progress toward goals and may
digress or regress from goals; goals can be eliminated.
• You should evaluate your feasible choices by calculating the benefits,
explicit costs, implicit costs, and the strategic costs of each one.

EXERCISES
1. Assess and summarize your current financial situation. What measures

are you using to describe where you are? Your assessment should
include an appreciation of your financial assets, debts, incomes, and
expenses.
2. Use the S.M.A.R.T. planning model and information in this

section to evaluate Alice’s goals. Write your answers in your
financial planning journal or My Notes and discuss your
evaluations with classmates.
a. Pay off student loan

b. Buy a house and save for children’s education
c. Accumulate assets
d. Retire
e. Travel around the world in a sailboat
3. Identify and prioritize your immediate, short-term, and long-term goals
at this time in your life. Why will you need different strategies to
achieve these goals? For each goal identify a range of alternatives for
achieving it. How will you evaluate each alternative before making a
decision?
4. In your personal financial journal or My Notes record specific

examples of your use of the following kinds of strategies in
making financial decisions:
a. Weigh costs and benefits

b. Respond to incentives
c. Learn from experience
d. Avoid a feared consequence or loss
e. Avoid risk
f. Throw caution to the wind
On average, would you rate yourself as more of a rational than

nonrational financial decision maker?

1.4 Financial Planning Professionals
LEARNING OBJECTIVES
1. Identify the professions of financial advisors.

2. Discuss how training and compensation may affect your choice of
advisor.
3. Describe the differences between objective and subjective advice and
how that may affect your choice of advisor.
4. Discuss how the kind of advice you need may affect your choice of
advisor.
Even after reading this book, or perhaps especially after reading this book, you may
want some help from a professional who specializes in financial planning. As with
any professional that you go to for advice, you want expertise to help make your
decisions, but in the end, you are the one who will certainly have to live with the
consequences of your decisions, and you should make your own decisions.
There are a multitude of financial advisors17 to help with financial planning, such
as accountants, investment advisors, tax advisors, estate planners, or insurance
agents. They have different kinds of training and qualifications, different
educations and backgrounds, and different approaches to financial planning. To
have a set of initials after their name, all have met educational and professional
experience requirements and have passed exams administered by professional
organizations, testing their knowledge in the field. Figure 1.17 "Professional
Classifications" provides a perspective on the industry classifications of financial
planning professionals.
17. Professionals with various

backgrounds and training who
give financial advice and assist
with personal and business
financial planning, including
tax, estate, and investment
planning.
39
Figure 1.17 Professional Classifications
Certifications are useful because they indicate training

and experience in a particular aspect of financial Figure 1.18
planning. When looking for advice, however, it is
important to understand where the advisor’s interests
lie (as well as your own). It is always important to know
where your information and advice come from and what
that means for the quality of that information and
advice. Specifically, how is the advisor compensated?
Some advisors just give, and get paid for, advice; some © 2010 Jupiterimages
Corporation
are selling a product, such as a particular investment or
mutual fund or life insurance policy, and get paid when
it gets sold. Others are selling a service, such as
brokerage or mortgage servicing, and get paid when the
service is used. All may be highly ethical and well intentioned, but when choosing a
financial planning advisor, it is important to be able to distinguish among them.
Sometimes a friend or family member who knows you well and has your personal
interests in mind may be a great resource for information and advice, but perhaps
1.4 Financial Planning Professionals 40

not as objective or knowledgeable as a disinterested professional. It is good to

diversify your sources of information and advice, using professional and “amateur,”
subjective and objective advisors. As always, diversification decreases risk.
Now you know a bit about the planning process, the personal factors that affect it,
the larger economic contexts, and the business of financial advising. The next steps
in financial planning get down to details, especially how to organize your financial
information to see your current situation and how to begin to evaluate your
alternatives.
References to Professional Organizations
The references that follow provide information for further research on the
professionals and professional organizations mentioned in the chapter.
• American Institute of Certified Public Accountants (AICPA):

http://www.aicpa.org.
• Canadian Institute of Chartered Accountants (CICA):
http://www.cica.ca.
• Association of Chartered Certified Accountants (ACCA):
http://www.accaglobal.com.
• Chartered Financial Analyst Institute: http://www.cfainstitute.org.
• Certified Financial Planner Board of Standards:
http://www.cfp.net.
• Financial Planners Standards Council of Canada:
http://www.fpsccanada.org.
• The American College: http://www.theamericancollege.edu.
• The Association for Financial Counseling and Planning Education:
http://www.afcpe.org.
• The National Association of Estate Planners and Councils:
http://www.naepc.org.
• U.S. Securities and Exchange Commission: http://www.sec.gov.
• Internal Revenue Service, U.S. Treasury Department:
http://www.irs.gov.

KEY TAKEAWAYS
• Financial advisors may be working as accountants, investment advisors,

tax advisors, estate planners, or insurance agents.
• You should always understand how your advisor is trained and how that
may be related to the kind of advice that you receive.
• You should always understand how your advisor is compensated and
how that may be related to the kind of advice that you receive.
• You should diversify your sources of information and advice by using
subjective advisors—friends and family—as well as objective,
professional advisors. Diversification, as always, reduces risk.
EXERCISES
1. Where do you get your financial advice? Identify all the sources. In what
circumstances might you seek a professional financial advisor?
2. View the video “Choosing a Financial Planner” at
http://videos.howstuffworks.com/marketplace/4105-choosing-a-
financial-planner-video.htm. Which advice about getting financial
advice do you find most valuable? Share your views with classmates.
Also view the MSN Money video on when people should consider getting
a financial advisor: http://video.msn.com/?mkt=en-
us&brand=money&vid=6f22019c-db6e-45de-984b-
a447f52dc4db&playlist=videoByTag:tag:
money_top_investing:ns:MSNmoney_Gallery:mk:us:vs:1&from=MSNmon
ey_8ThinsYourFinanical PlannerWontTellYou&tab=s216. According to
the featured speaker, is financial planning advice for everyone? How do
you know when you need a financial planner?
3. Explore the following links for more information on financial

advisors:
a. National Association of Personal Financial Advisors

(http://www.napfa.org)
b. U.S. Department of Labor Bureau of Labor Statistics on the
job descriptions, training requirements, and earnings of
financial analysts and personal financial advisors
(http://www.bls.gov/oco/ocos259.htm)
c. The Motley Fool’s guidelines for choosing a financial advisor
(http://www.fool.com/fa/finadvice.htm)

Chapter 2
Basic Ideas of Finance
Introduction
Money, says the proverb, makes money. When you have got a little, it is often easy
to get more. The great difficulty is to get that little.
- Adam Smith, The Wealth of NationsAdam Smith, The Wealth of Nations (New York:
The Modern Library, 2000), Book I, Chapter ix. Originally published in 1776.
Personal finance addresses the “great difficulty” of getting a little money. It is about
learning to manage income and wealth to satisfy desires in life or to create more
income and more wealth. It is about creating productive assets1 and about
protecting existing and expected value in those assets. In other words, personal
finance is about learning how to get what you want and how to protect what you’ve
got.
There is no trick to managing personal finances. Making good financial decisions is

largely a matter of understanding how the economy works, how money flows
through it, and how people make financial decisions. The better your
understanding, the better your ability to plan, take advantage of opportunities, and
avoid disappointments. Life can never be planned entirely, of course, and the best-
laid plans do go awry, but anticipating risks and protecting against them can
minimize exposure to the inevitable mistakes and “the hazards and
vicissitudes”Franklin D. Roosevelt, remarks when signing the Social Security Act,
August 14, 1935. Retrieved from the Social Security Administration archives,
http://www.socialsecurity.gov/history/fdrstmts.html#signing (accessed November
23, 2009). of life.
1. Resources that can be used to

create future economic benefit,
such as increasing income,
decreasing expenses, or storing
wealth, as an investment.
43
Chapter 2 Basic Ideas of Finance
2.1 Income and Expenses
LEARNING OBJECTIVES
1. Identify and compare the sources and uses of income.

2. Define and illustrate the budget balances that result from the uses of
income.
3. Outline the remedies for budget deficits and surpluses.
4. Define opportunity and sunk costs and discuss their effects on financial
decision making.
Personal finance is the process of paying for or financing a life and a way of living.
Just as a business must be financed—its buildings, equipment, use of labor and
materials, and operating costs must be paid for—so must a person’s possessions and
living expenses. Just as a business relies on its revenues from selling goods or
services to finance its costs, so a person relies on income earned from selling labor
or capital to finance costs. You need to understand this financing process and the
terms used to describe it. In the next chapter, you’ll look at how to account for it.
Where Does Income Come From?
Income2 is what is earned or received in a given period. There are various terms for
income because there are various ways of earning income. Income from
employment or self-employment is wages or salary. Deposit accounts, like savings
accounts, earn interest, which could also come from lending. Owning stock entitles
the shareholder to a dividend, if there is one. Owning a piece of a partnership or a
privately held corporation entitles one to a draw.
The two fundamental ways of earning income in a market-based economy are by

selling labor or selling capital. Selling labor means working, either for someone else
or for yourself. Income comes in the form of a paycheck. Total compensation may
include other benefits, such as retirement contributions, health insurance, or life
insurance. Labor is sold in the labor market.
2. Earnings of a given period. In
the case of an indivdual or
household, this is generally
cash from wages, interest,
dividends, or assets (such as
rental income from real estate)
that can be used for
consumption or saved.
44
Selling capital means investing: taking excess cash and

selling it or renting it to someone who needs liquidity3 Figure 2.1
(access to cash). Lending is renting out capital; the
interest is the rent. You can lend privately by direct
arrangement with a borrower, or you can lend through
a public debt exchange by buying corporate,
government, or government agency bonds. Investing in
or buying corporate stock is an example of selling
capital in exchange for a share of the company’s future
value.
You can invest in many other kinds of assets, like © 2010 Jupiterimages
antiques, art, coins, land, or commodities such as Corporation
soybeans, live cattle, platinum, or light crude oil. The
principle is the same: investing is renting capital or
selling it for an asset that can be resold later, or that can
create future income, or both. Capital is sold in the
capital market and lent in the credit market—a specific part of the capital market
(just like the dairy section is a specific part of the supermarket). Figure 2.2 "Sources
of Income" shows the sources of income.
Figure 2.2 Sources of Income
In the labor market, the price of labor is the wage that an employer (buyer of labor)
is willing to pay to the employee (seller of labor). For any given job, that price is
determined by many factors. The nature of the work defines the education and
3. Nearness to cash, or how easily skills required, and the price may reflect other factors as well, such as the status or
and cheaply—with low desirability of the job.
transaction costs—an asset can
be turned into cash.
2.1 Income and Expenses 45

In turn, the skills needed and the attractiveness of the work determine the supply
of labor for that particular job—the number of people who could and would want to
do the job. If the supply of labor is greater than the demand, if there are more
people to work at a job than are needed, then employers will have more hiring
choices. That labor market is a buyers’ market, and the buyers can hire labor at
lower prices. If there are fewer people willing and able to do a job than there are
jobs, then that labor market is a sellers’ market, and workers can sell their labor at
higher prices.
Similarly, the fewer skills required for the job, the more people there will be who
are able to do it, creating a buyers’ market. The more skills required for a job, the
fewer people there will be to do it, and the more leverage or advantage the seller
has in negotiating a price. People pursue education to make themselves more highly
skilled and therefore able to compete in a sellers’ labor market.
When you are starting your career, you are usually in a buyers’ market (unless you
have some unusual gift or talent), if only because of your lack of experience. As your
career progresses, you have more, and perhaps more varied, experience and
presumably more skills, and so can sell your labor in more of a sellers’ market. You
may change careers or jobs more than once, but you would hope to be doing so to
your advantage, that is, always to be gaining bargaining power in the labor market.
Many people love their work for many reasons other than the pay, however, and
choose it for those rewards. Labor is more than a source of income; it is also a
source of many intellectual, social, and other personal gratifications. Your labor
nevertheless is also a tradable commodity and has a market value. The personal
rewards of your work may ultimately determine your choices, but you should be
aware of the market value of those choices as you make them.
Your ability to sell labor and earn income reflects your situation in your labor
market. Earlier in your career, you can expect to earn less than you will as your
career progresses. Most people would like to reach a point where they don’t have to
sell labor at all. They hope to retire someday and pursue other hobbies or interests.
They can retire if they have alternative sources of income—if they can earn income
from savings and from selling capital.
Capital markets exist so that buyers can buy capital. Businesses always need capital
and have limited ways of raising it. Sellers and lenders (investors), on the other
hand, have many more choices of how to invest their excess cash in the capital and
credit markets, so those markets are much more like sellers’ markets. The following
are examples of ways to invest in the capital and credit markets:

• Buying stocks
• Buying government or corporate bonds
• Lending a mortgage
The market for any particular investment or asset may be a sellers’ or buyers’
market at any particular time, depending on economic conditions. For example, the
market for real estate, modern art, sports memorabilia, or vintage cars can be a
buyers’ market if there are more sellers than buyers. Typically, however, there is as
much or more demand for capital as there is supply. The more capital you have to
sell, the more ways you can sell it to more kinds of buyers, and the more those
buyers may be willing to pay. At first, however, for most people, selling labor is
their only practical source of income.
Where Does Income Go?
Expenses4 are costs for items or resources that are used up or consumed in the
course of daily living. Expenses recur (i.e., they happen over and over again)
because food, housing, clothing, energy, and so on are used up on a daily basis.
When income is less than expenses, you have a budget deficit5—too little cash to
provide for your wants or needs. A budget deficit is not sustainable; it is not
financially viable. The only choices are to eliminate the deficit by (1) increasing
income, (2) reducing expenses, or (3) borrowing to make up the difference.
Borrowing may seem like the easiest and quickest solution, but borrowing also
increases expenses, because it creates an additional expense: interest. Unless
income can also be increased, borrowing to cover a deficit will only increase it.
Better, although usually harder, choices are to increase income or decrease

expenses. Figure 2.3 "Budget Deficit" shows the choices created by a budget deficit.
Figure 2.3 Budget Deficit
4. The costs of consumption or

daily living.
5. A shortfall of available funds

created when income is less
than the expenses.

When income for a period is greater than expenses, there is a budget surplus6.
That situation is sustainable and remains financially viable. You could choose to
decrease income by, say, working less. More likely, you would use the surplus in one
of two ways: consume more or save it. If consumed, the income is gone, although
presumably you enjoyed it.
If saved, however, the income can be stored, perhaps in a piggy bank or cookie jar,
and used later. A more profitable way to save is to invest it in some way—deposit in
a bank account, lend it with interest, or trade it for an asset, such as a stock or a
bond or real estate. Those ways of saving are ways of selling your excess capital in
the capital markets to increase your wealth. The following are examples of savings:
1. Depositing into a statement savings account at a bank

2. Contributing to a retirement account
3. Purchasing a certificate of deposit (CD)
4. Purchasing a government savings bond
5. Depositing into a money market account
Figure 2.5 "Budget Surplus" shows the choices created

by a budget surplus. Figure 2.4
Figure 2.5 Budget Surplus
Corporation
6. An excess of available funds

created when income is greater
than the expenses.

Opportunity Costs and Sunk Costs
There are two other important kinds of costs aside from expenses that affect your
financial life. Suppose you can afford a new jacket or new boots, but not both,
because your resources—the income you can use to buy clothing—are limited. If you
buy the jacket, you cannot also buy the boots. Not getting the boots is an
opportunity cost7 of buying the jacket; it is cost of sacrificing your next best
choice.
In personal finance, there is always an opportunity cost. You always want to make a
choice that will create more value than cost, and so you always want the
opportunity cost to be less than the benefit from trade. You bought the jacket
instead of the boots because you decided that having the jacket would bring more
benefit than the cost of not having the boots. You believed your benefit would be
greater than your opportunity cost.
In personal finance, opportunity costs affect not only consumption decisions but
also financing decisions, such as whether to borrow or to pay cash. Borrowing has
obvious costs, whereas paying with your own cash or savings seems costless. Using
your cash does have an opportunity cost, however. You lose whatever interest you
may have had on your savings, and you lose liquidity—that is, if you need cash for
something else, like a better choice or an emergency, you no longer have it and may
even have to borrow it at a higher cost.
When buyers and sellers make choices, they weigh opportunity costs, and
sometimes regret them, especially when the benefits from trade are disappointing.
Regret can color future choices. Sometimes regret can keep us from recognizing
sunk costs8.
Sunk costs are costs that have already been spent; that is, whatever resources you
traded are gone, and there is no way to recover them. Decisions, by definition, can
be made only about the future, not about the past. A trade, when it’s over, is over
and done, so recognizing that sunk costs are truly sunk can help you make better
decisions.
7. The cost of sacrificing the next For example, the money you spent on your jacket is a sunk cost. If it snows next
best choice because of the
choice made; the value of the week and you decide you really do need boots, too, that money is gone, and you
next best choice, which is cannot use it to buy boots. If you really want the boots, you will have to find
forgone once a choice is made. another way to pay for them.
8. Costs that have been incurred
in past transactions and cannot
be recovered.

Unlike a price tag, opportunity cost is not obvious. You tend to focus on what you
are getting in the trade, not on what you are not getting. This tendency is a cheerful
aspect of human nature, but it can be a weakness in the kind of strategic decision
making that is so essential in financial planning. Human nature also may make you
focus too much on sunk costs, but all the relish or regret in the world cannot
change past decisions. Learning to recognize sunk costs is important in making
good financial decisions.
KEY TAKEAWAYS
• It is important to understand the sources (incomes) and uses (expenses)

of funds, and the budget deficit or budget surplus that may result.
• Wages or salary is income from employment or self-employment;
interest is earned by lending; a dividend is the income from owning
corporate stock; and a draw is income from a partnership.
• Deficits or surpluses need to be addressed, and that means making
decisions about what to do with them.
• Increasing income, reducing expenses, and borrowing are three ways to
deal with budget deficits.
• Spending more, saving, and investing are three ways to deal with budget
surpluses.
• Opportunity costs and sunk costs are hidden expenses that affect
financial decision making.

EXERCISES
1. Where does your income come from, and where does it go? Analyze your
inflows of income from all sources and outgoes of income through
expenditures in a month, quarter, or year. After analyzing your numbers
and converting them to percentages, show your results in two figures,
using proportions of a dollar bill to show where your income comes
from and proportions of another dollar bill to show how you spend your
income. How would you like your income to change? How would you like
your distribution of expenses to change? Use your investigation to
develop a rough personal budget.
2. Examine your budget and distinguish between wants and needs. How do
you define a financial need? What are your fixed expenses, or costs you
must pay regularly each week, month, or year? Which of your budget
categories must you provide for first before satisfying others? To what
extent is each of your expenses discretionary—under your control in
terms of spending more or less for that item or resource? Which of your
expenses could you reduce if you had to or wanted to for any reason?
3. If you had a budget deficit, what could you do about it? What would be
the best solution for the long term? If you had a budget surplus, what
could you do about it? What would be your best choice, and why?
4. You need a jacket, boots, and gloves, but the jacket you want will use up
all the money you have available for outerwear. What is your
opportunity cost if you buy the jacket? What is your sunk cost if you buy
the jacket? How could you modify your consumption to reduce
opportunity cost? If you buy the jacket but find that you need the boots
and gloves, how could you modify your budget to compensate for your
sunk cost?

2.2 Assets
LEARNING OBJECTIVES
1. Identify the purposes and uses of assets.

2. Identify the types of assets.
3. Explain the role of assets in personal finance.
4. Explain how a capital gain or loss is created.
As defined earlier in this chapter, an asset is any item with economic value that can
be converted to cash. Assets are resources that can be used to create income or
reduce expenses and to store value. The following are examples of tangible
(material) assets:
• Car
• Savings account
• Wind-up toy collection
• Money market account
• Shares of stock
• Forty acres of farmland
• Home
When you sell excess capital in the capital markets in exchange for an asset, it is a
way of storing wealth, and hopefully of generating income as well. The asset is your
investment—a use of your liquidity. Some assets are more liquid than others. For
example, you can probably sell your car more quickly than you can sell your house.
As an investor, you assume that when you want your liquidity back, you can sell the
asset. This assumes that it has some liquidity and market value (some use and value
to someone else) and that it trades in a reasonably efficient market. Otherwise, the
asset is not an investment, but merely a possession, which may bring great
happiness but will not serve as a store of wealth.
Assets may be used to store wealth, create income, and reduce future expenses.
52
Assets Store Wealth
If the asset is worth more when it is resold than it was

Figure 2.6
when it was bought, then you have earned a capital
gain9: the investment has not only stored wealth but
also increased it. Of course, things can go the other way
too: the investment can decrease in value while owned
and be worth less when resold than it was when bought.
In that case, you have a capital loss10. The investment
not only did not store wealth, it lost some. Figure 2.7
"Gains and Losses" shows how capital gains and losses
are created.
Figure 2.7 Gains and Losses
Corporation
The better investment asset is the one that increases in value—creates a capital
gain—during the time you are storing it.
Assets Create Income
Some assets not only store wealth but also create income. An investment in an
apartment house stores wealth and creates rental income, for example. An
9. Wealth created when an asset
is sold for more than the
investment in a share of stock stores wealth and also perhaps creates dividend
original investment. income. A deposit in a savings account stores wealth and creates interest income.
10. Wealth lost when an asset is

sold for less than the original
investment.
2.2 Assets 53
Some investors care more about increasing asset value than about income. For
example, an investment in a share of corporate stock may produce a dividend,
which is a share of the corporation’s profit, or the company may keep all its profit
rather than pay dividends to shareholders. Reinvesting that profit in the company
may help the company to increase in value. If the company increases in value, the
stock increases in value, increasing investors’ wealth. Further, increases in wealth
through capital gains are taxed differently than income, making capital gains more
valuable than an increase in income for some investors.
On the other hand, other investors care more about receiving income from their
investments. For example, retirees who no longer have employment income may be
relying on investments to provide income for living expenses. Being older and
having a shorter horizon, retirees may be less concerned with growing wealth than
with creating income.
Assets Reduce Expenses
Some assets are used to reduce living expenses. Purchasing an asset and using it
may be cheaper than arranging for an alternative. For example, buying a car to
drive to work may be cheaper, in the long run, than renting one or using public
transportation. The car typically will not increase in value, so it cannot be expected
to be a store of wealth; its only role is to reduce future expenses.
Sometimes an asset may be expected to both store wealth and reduce future
expenses. For example, buying a house to live in may be cheaper, in the long run,
than renting one. In addition, real estate may appreciate in value, allowing you to
realize a gain when you sell the asset. In this case, the house has effectively stored
wealth. Appreciation in value depends on the real estate market and demand for
housing when the asset is sold, however, so you cannot count on it. Still, a house
usually can reduce living expenses and be a potential store of wealth.
Figure 2.8 "Assets and the Roles of Assets" shows the roles of assets in reducing
expenses, increasing income, and storing wealth.
2.2 Assets 54
Figure 2.8 Assets and the Roles of Assets
The choice of investment asset, then, depends on your belief in its ability to store
and increase wealth, create income, or reduce expenses. Ideally, your assets will
store and increase wealth while increasing income or reducing expenses. Otherwise,
acquiring the asset will not be a productive use of liquidity. Also, in that case the
opportunity cost will be greater than the benefit from the investment, since there
are many assets to choose from.
2.2 Assets 55
KEY TAKEAWAYS
• Assets are items with economic value that can be converted to cash. You
use excess liquidity or surplus cash to buy an asset and store wealth
until you resell the asset.
• An asset can create income, reduce expenses, and store wealth.
• To have value as an investment, an asset must either store wealth or
create income (reduce expenses); ideally, an asset can do both.
• Whatever the type of asset you choose, investing in assets or selling
capital can be more profitable than selling labor.
• Selling an asset can result in a capital gain or capital loss.
• Selling capital means trading in the capital markets, which is a sellers’
market. You can do this only if you have a budget surplus, or an excess
of income over expenses.
EXERCISES
1. Record your answers to the following questions in your personal finance

journal or My Notes. What are your assets? How do your assets store
your wealth? How do your assets make income for you? How do your
assets help you reduce your expenses?
2. List your assets in the order of their cash or market value (most valuable
to least valuable). Then list them in terms of their degree of liquidity.
Which assets do you think you might sell in the next ten years? Why?
What new assets do you think you would like to acquire and why? How
could you reorganize your budget to make it possible to invest in new
assets?
2.2 Assets 56
2.3 Debt and Equity
LEARNING OBJECTIVES
1. Define equity and debt.

2. Compare and contrast the benefits and costs of debt and equity.
3. Illustrate the uses of debt and equity.
4. Analyze the costs of debt and of equity.
Buying capital, that is, borrowing enables you to invest without first owning capital.
By using other people’s money to finance the investment, you get to use an asset
before actually owning it, free and clear, assuming you can repay out of future
earnings.
Borrowing capital has costs, however, so the asset will have to increase wealth,
increase earnings, or decrease expenses enough to compensate for its costs. In
other words, the asset will have to be more productive to earn enough to cover its
financing costs—the cost of buying or borrowing capital to buy the asset.
Buying capital gives you equity, borrowing capital gives you debt, and both kinds of
financing have costs and benefits. When you buy or borrow liquidity or cash, you
become a buyer in the capital market.
The Costs of Debt and Equity
You can buy capital from other investors in exchange for an ownership share or
equity11, which represents your claim on any future gains or future income. If the
asset is productive in storing wealth, generating income, or reducing expenses, the
equity holder or shareholder or owner enjoys that benefit in proportion to the
share of the asset owned. If the asset actually loses value, the owner bears a portion
of the loss in proportion to the share of the asset owned. The cost of equity12 is in
11. An ownership share in an asset, having to share the benefits from the investment.
entitling the holder to a share
of the future gain (or loss) in
asset value and of any future For example, in 2004 Google, a company that produced a very successful Internet
income (or loss) created. search engine, decided to buy capital by selling shares of the company (shares of
12. The cost of having to share the stock or equity securities) in exchange for cash. Google sold over 19 million shares
benefits—capital gains or for a total of $1.67 billion. Those who bought the shares were then owners or
income (dividends)—from the shareholders of Google, Inc. Each shareholder has equity in Google, and as long as
investment.
57
they own the shares they will share in the profits and value of Google, Inc. The
original founders and owners of Google, Larry Page and Sergey Brin, have since had
to share their company’s gains (or income) or losses with all those shareholders. In
this case, the cost of equity is the minimum rate of return Google must offer its
shareholders to compensate them for waiting for their returns and for bearing
some risk13 that the company might not do as well in the future.
Borrowing is renting someone else’s money for a period of time, and the result is
debt14. During that period of time, rent or interest15 must be paid, which is a cost
of debt16. When that period of time expires, all the capital (the principal17 amount
borrowed) must be given back. The investment’s earnings must be enough to cover
the interest, and its growth in value must be enough to return the principal. Thus,
debt is a liability, an obligation for which the borrower is liable.
In contrast, the cost of equity may need to be paid only if there is an increase in
income or wealth, and even then can be deferred. So, from the buyer’s point of
view, purchasing liquidity by borrowing (debt) has a more immediate effect on
income and expenses. Interest must be added as an expense, and repayment must
be anticipated.
Figure 2.9 "Sources of Capital" shows the implications of equity and debt as the
sources of capital.
Figure 2.9 Sources of Capital
13. In finance, the probability that

the value of an asset, income,
or investment may decline in
the future.
14. Borrowed capital, a liability, a

loan that must be repaid.
15. The cost of debt expressed as

an annual percentage of the
principal.
16. The cost of borrowing capital

because of having to pay
interest on the principal.
17. The original amount of

borrowed capital (a loan).
2.3 Debt and Equity 58

The Uses of Debt and Equity
Debt is a way to make an investment that could not otherwise be made, to buy an
asset (e.g., house, car, corporate stock) that you couldn’t buy without borrowing. If
that asset is expected to provide enough benefit (i.e., increase value or create
income or reduce expense) to compensate for its additional costs, then the debt is
worth it. However, if debt creates additional expense without enough additional
benefit, then it is not worth it. The trouble is, while the costs are usually known up
front, the benefits are not. That adds a dimension of risk to debt, which is another
factor in assessing whether it’s desirable.
For example, after the housing boom began to go bust in

2008, homeowners began losing value in their homes as Figure 2.10
housing prices dropped. Some homeowners are in the
unfortunate position of owing more on their mortgage
than their house is currently worth. The costs of their
debt were knowable upfront, but the consequences—the
house losing value and becoming worth less than the
debt—were not.
Debt may also be used to cover a budget deficit, or the

excess of expenses over income. As mentioned
previously, however, in the long run the cost of the debt
will increase expenses that are already too big, which is
what created the deficit in the first place. Unless income
can also be increased, debt can only aggravate a deficit.
The Value of Debt Corporation
The value of debt includes the benefits of having the

asset sooner rather than later, something that debt
financing enables. For example, many people want to buy a house when they have
children, perhaps because they want bedrooms and bathrooms and maybe a yard
for their children. Not far into adulthood, would-be homebuyers may not have had
enough time to save enough to buy the house outright, so they borrow to make up
the difference. Over the length of their mortgage (real estate loan), they pay the
interest.
The alternative would be to rent a living space. If the rent on a comparable home
were more than the mortgage interest (which it often is, because a landlord usually
wants the rent to cover the mortgage and create a profit), it would make more
sense, if possible, to borrow and buy a home and be able to live in it. And, extra

bedrooms and bathrooms and a yard are valuable while children are young and live
at home. If you wait until you have saved enough to buy a home, you may be much
older, and your children may be off on their own.
Another example of the value of debt is using debt to finance an education.

Education is valuable because it has many benefits that can be enjoyed over a
lifetime. One benefit is an increase in potential earnings in wages and salaries.
Demand for the educated or more skilled employee is generally greater than for the
uneducated or less-skilled employee. So education creates a more valuable and thus
higher-priced employee.
It makes sense to be able to maximize value by becoming educated as soon as

possible so that you have as long as possible to benefit from increased income. It
even makes sense to invest in an education before you sell your labor because your
opportunity cost of going to school—in this case, the “lost” wages of not
working—is lowest. Without income or savings (or very little) to finance your
education, typically, you borrow. Debt enables you to use the value of the education
to enhance your income, out of which you can pay back the debt.
The alternative would be to work and save and then get an education, but you
would be earning income less efficiently until you completed your education, and
then you would have less time to earn your return. Waiting decreases the value of
your education, that is, its usefulness, over your lifetime.
In these examples (Figure 2.11 "Debt: Uses, Value, and Cost"), debt creates a cost,
but it reduces expenses or increases income to offset that cost. Debt allows this to
happen sooner than it otherwise could, which allows you to realize the maximum
benefit for the investment. In such cases, debt is “worth” it.

Figure 2.11 Debt: Uses, Value, and Cost
KEY TAKEAWAYS
• Financing assets through equity means sharing ownership and whatever

gains or losses that brings.
• Financing assets through borrowing and creating debt means taking on
a financial obligation that must be repaid.
• Both equity and debt have costs and value.
• Both equity and debt enable you to use an asset sooner than you
otherwise could and therefore to reap more of its rewards.

EXERCISES
1. Research the founding of Google online—for example, at

http://www.ubergizmo.com/15/archives/2008/09/
googles_first_steps.html and http://www.ted.com/index.php/speakers/
sergey_brin_and_ larry_page.html. How did the young entrepreneurs
Larry Page and Sergey Brin use equity and debt to make their business
successful and increase their personal wealth? Discuss your findings
with classmates.
2. Record your answers to the following questions in your personal finance
journal or My Notes. What equity do you own? What debt do you owe? In
each case what do your equity and debt finance? What do they cost you?
How do they benefit you?
3. View the video “Paying Off Student Loans”:

http://videos.howstuffworks.com/marketplace/4099-paying-off-
student-loans-video.htm. Students fear going into debt for their
education or later have difficulty paying off student loans. This
video presents personal financial planning strategies for
addressing this issue.
a. What are four practical financial planning tips to take

advantage of debt financing of your education?
b. If payments on student loans become overwhelming, what
should you do to avoid default?

2.4 Income and Risk
LEARNING OBJECTIVES
1. Describe how sources of income may be diversified.

2. Describe how investments in assets may be diversified.
3. Explain the use of diversification as a risk management strategy.
Personal finance is not just about getting what you want; it is also about protecting
what you have. Since the way to accumulate assets is to create surplus capital by
having an income larger than expenses, and since you rely on income to provide for
living expenses, you also need to think about protecting your income. One way to
do so is through diversification18, or spreading the risk.
You already know not to put all your eggs in one basket, because if something
happens to that basket, all the eggs are gone. If the eggs are in many baskets, on the
other hand, the loss of any one basket would mean the loss of just a fraction of the
eggs. The more baskets, the smaller your proportional loss would be. Then if you
put many different baskets in many different places, your eggs are diversified even
more effectively, because all the baskets aren’t exposed to the same environmental
or systematic risks.
Diversification is more often discussed in terms of investment decisions, but

diversification of sources of income works the same way and makes the same kind
of sense for the same reasons. If sources of income are diverse—in number and
kind—and one source of income ceases to be productive, then you still have others
to rely on.
If you sell your labor to only one buyer, then you are exposed to more risk than if
you can generate income by selling your labor to more than one buyer. You have
only so much time you can devote to working, however. Having more than one
employer could be exhausting and perhaps impossible. Selling your labor to more
than one buyer also means that you are still dependent on the labor market, which
could suffer from an economic cycle such as a recession affecting many buyers
(employers).
18. The strategy of reducing risk
by spreading income and
investments among a number Mark, for example, works as a school counselor, tutors on the side, paints houses in
of different kinds, sources, and the summers, and buys and sells sports memorabilia on the Internet. If he got laid
locations.
63
off from his counseling job, he would lose his paycheck but still be able to create
income by tutoring, painting, and trading memorabilia.
Similarly, if you sell your capital to only one buyer—invest in only one asset—then
you are exposed to more risk than if you generate income by investing in a variety
of assets. Diversifying investments means you are dependent on trade in the capital
markets, however, which likewise could suffer from unfavorable economic
conditions.
Mark has a checking account, an online money market account, and a balanced
portfolio of stocks. If his stock portfolio lost value, he would still have the value in
his money market account.
A better way to diversify sources of income is to sell both labor and capital. Then
you are trading in different markets, and are not totally exposed to risks in either
one. In Mark’s case, if all his incomes dried up, he would still have his investments,
and if all his investments lost value, he would still have his paycheck and other
incomes. To diversify to that extent, you need surplus capital to trade. This brings
us full circle to Adam Smith, quoted at the beginning of this chapter, who said,
essentially, “It takes money to make money.”
KEY TAKEAWAY
Diversifying sources of income in both the labor market and the capital
markets is the best hedge against risks in any one market.
EXERCISE
Record your answers to the following questions in your personal finance

journal or My Notes. How can you diversify your sources of income to spread
the risk of losing income? How can you diversify your investments to spread
the risk of losing return on investment?
2.4 Income and Risk 64

Chapter 3
Financial Statements
Introduction
Man is the measure of all things; of that which is, that it is; of that which is not, that
it is not.
- Protagoras (ca. 490–421 BC), in Plato’s Protagoras
Man is also the measurer of all things. Measuring by

counting, by adding it all up, by taking stock, is Figure 3.1
probably as old as any human activity. In recorded
history, there are “accounts” on clay tablets from
ancient Sumeria dating from ca. 3,700 BC.Gary Giroux,
http://acct.tamu.edu/giroux/AncientWorld.html
(accessed January 19, 2009). Since the first shepherd
counted his sheep, there has been accounting.
In financial planning, assessing the current situation, or © 2010 Jupiterimages

Corporation
figuring out where you are at present, is crucial to
determining any sort of financial plan. This assessment
becomes the point of departure for any strategy. It
becomes the mark from which any progress is
measured, the principal from which any return is calculated. It can determine the
practical or realistic goals to have and the strategies to achieve them. Eventually,
the current situation becomes a time forgotten with the pride of success, or
remembered with the regret of failure.
Understanding the current situation is not just a matter of measuring it, but also of
putting it in perspective and in context, relative to your own past performance and
future goals, and relative to the realities in the economic world around you. Tools
for understanding your current situation are your accounting and financial
statements.
65
Chapter 3 Financial Statements
3.1 Accounting and Financial Statements
LEARNING OBJECTIVES
1. Distinguish accrual and cash accounting.

2. Compare and contrast the three common financial statements.
3. Identify the results shown on the income statement, balance sheet, and
cash flow statement.
4. Explain the calculation and meaning of net worth.
5. Trace how a bankruptcy can occur.
Clay tablets interested Sumerian traders because the records gave them a way to
see their financial situation and to use that insight to measure progress and plan for
the future. The method of accounting universally used in business today is known
as accrual accounting1, in which events are accounted for even if cash does not
change hands. That is, transactions are recorded at the time they occur rather than
when payment is actually made or received. Anticipated or preceding payments and
receipts (cash flows) are recorded as accrued or deferred. Accrual accounting is the
opposite of cash accounting2, in which transactions are recognized only when cash
is exchanged.
Accrual accounting defines earning as an economic event signified by an exchange

of goods rather than by an exchange of cash. In this way, accrual accounting allows
for the separation in time of the exchange of goods and the exchange of cash. A
transaction can be completed over time and distance, which allows for
extended—and extensive—trade. Another advantage of accrual accounting is that it
gives a business a more accurate picture of its present situation in reality.
1. A method of accounting in
which economic consequences
rather than cash flow
consequences define
transactions.
2. A method of accounting in
which cash flow consequences
rather than economic
consequences define
transactions. Events are
defined as cash transactions
and recorded only when cash
changes hands.
66
Modern accounting techniques developed during the

European Age of Discovery, which was motivated by Figure 3.2
ever-expanding trade. Both the principles and the
methods of modern accrual accounting were first
published in a text by Luca Pacioli in 1494,Luca Pacioli,
Summa de arithmetica, geometria, proportioni et
proportionalita (Venice: Luca Pacioli, 1494). For more
information on Pacioli, see http://en.wikipedia.org/
wiki/Luca_Pacioli (accessed November 23, 2009).
although they were probably developed even before
that. These methods of “keeping the books” can be
applied to personal finance today as they were to
trading in the age of long voyages for pepper and cloves,
and with equally valuable results.
Nevertheless, in personal finance it almost always © 2010 Jupiterimages

makes more sense to use cash accounting, to define and Corporation
account for events when the cash changes hands. So in
personal finance, incomes and expenses are noted when
the cash is received or paid, or when the cash flows.
The Accounting Process
Financial decisions result in transactions, actual trades that buy or sell, invest or
borrow. In the market economy, something is given up in order to get something,
so each trade involves at least one thing given up and one thing gotten—two things
flowing in at least two directions. The process of accounting records these
transactions and records what has been gotten and what has been given up to get it,
what flows in and what flows out.
In business, accounting journals and ledgers are set up to record transactions as

they happen. In personal finance, a checkbook records most transactions, with
statements from banks or investment accounts providing records of the rest.
Periodically, the transaction information is summarized in financial statements so
it can be read most efficiently.
Bookkeeping—the process of recording what and how and by how much a

transaction affects the financial situation—is how events are recorded. Since the
advent of accounting software, bookkeeping, like long division and spelling, has
become somewhat obsolete, although human judgment is still required. What is
more interesting and useful are the summary reports that can be produced once all
3.1 Accounting and Financial Statements 67

this information is recorded: the income statement, cash flow statement, and
balance sheet.
Income Statement
The income statement3 summarizes incomes and expenses for a period of time. In
business, income is the value of whatever is sold, expenses are the costs of earning
that income, and the difference is profit. In personal finance, income is what is
earned as wages or salary and as interest or dividends, and expenses are the costs of
things consumed in the course of daily living: the costs of sustaining you while you
earn income. Thus, the income statement is a measure of what you have earned and
what your cost of living was while earning it. The difference is personal profit,
which, if accumulated as investment, becomes your wealth.
The income statement clearly shows the relative size of your income and expenses.
If income is greater than expenses, there is a surplus, and that surplus can be used
to save or to spend more (and create more expenses). If income is less than
expenses, then there is a deficit that must be addressed. If the deficit continues, it
creates debts—unpaid bills—that must eventually be paid. Over the long term, a
deficit is not a viable scenario.
The income statement can be useful for its level of detail too. You can see which of
your expenses consumes the greatest portion of your income or which expense has
the greatest or least effect on your bottom line. If you want to reduce expenses, you
can see which would have the greatest impact or would free up more income if you
reduced it. If you want to increase income, you can see how much more that would
buy you in terms of your expenses (Figure 3.3 "Alice’s Situation (in Dollars)"). For
example, consider Alice’s situation per year.
Figure 3.3 Alice’s Situation (in Dollars)
3. A summary statement of She also had car payments of $2,400 and student loan payments of $7,720. Each loan
income and expenses for a payment actually covers the interest expense and partial repayment of the loan.
period; an income statement
shows the difference between The interest is an expense representing the cost of borrowing, and thus of having,
them or the net profit (net the car and the education. The repayment of the loan is not an expense, however,
loss) for the period.

but is just giving back something that was borrowed. In this case, the loan payments
break down as follows (Figure 3.4 "Alice’s Loan Payments (Annually)").
Figure 3.4 Alice’s Loan Payments (Annually)
Breaking down Alice’s living expenses in more detail and adding in her interest
expenses, Alice’s income statement would look like this (Figure 3.5 "Alice’s Income
Statement for the Year 2009").
Figure 3.5 Alice’s Income Statement for the Year 2009

Alice’s disposable income4, or income to meet expenses after taxes have been
accounted for, is $35,720. Alice’s net ncome, or net earnings or personal profit, is
the remaining income after all other expenses have been deducted, in this case
$6,040.
Now Alice has a much clearer view of what’s going on in her financial life. She can
see, for example, that living expenses take the biggest bite out of her income and
that rent is the biggest single expense. If she wanted to decrease expenses, finding a
place to live with a cheaper rent will make the most impact on her bottom line. Or
perhaps it would make more sense to make many small changes rather than one
large change, to cut back on several other expenses. She could begin by cutting back
on the expense items that she feels are least necessary or that she could most easily
live without. Perhaps she could do with less entertainment or clothing or travel, for
example. Whatever choices she subsequently made would be reflected in her
income statement. The value of the income statement is in presenting income and
expenses in detail for a particular period of time.
Cash Flow Statement
The cash flow statement5 shows how much cash came in and where it came from,
and how much cash went out and where it went over a period of time. This differs
from the income statement because it may include cash flows that are not from
income and expenses. Examples of such cash flows would be receiving repayment of
money that you loaned, repaying money that you borrowed, or using money in
exchanges such as buying or selling an asset.
The cash flow statement is important because it can show how well you do at
creating liquidity, as well as your net income. Liquidity is nearness to cash, and
liquidity has value. An excess of liquidity can be sold or lent, creating additional
income. A lack of liquidity must be addressed by buying it or borrowing, creating
additional expense.
Looking at Alice’s situation, she has two loan repayments that are not expenses and
so are not included on her income statement. These payments reduce her liquidity,
4. Income available for expenses however, making it harder for her to create excess cash. Her cash flow statement
after tax expense has been
deducted; gross income less looks like this (Figure 3.6 "Alice’s Cash Flow Statement for the Year 2009").
income tax.
5. A summary of actual cash flows

for a period, detailing the
sources and uses of cash and
classifying them as from
operating, investing, or
financing activities.

Figure 3.6 Alice’s Cash Flow Statement for the Year 2009
Note: On a cash flow statement, negative and positive numbers indicate direction of flow. A negative number is cash
flowing out, and a positive number is cash flowing in. Conventionally, negative numbers are in parentheses.
As with the income statement, the cash flow statement is more useful if there are
subtotals for the different kinds of cash flows, as defined by their sources and uses.
The cash flows from income and expenses are operating cash flows6, or cash flows
that are a consequence of earning income or paying for the costs of earning income.
The loan repayments are cash flows from financing7 assets or investments that
will increase income. In this case, cash flows from financing include repayments on
the car and the education. Although Alice doesn’t have any in this example, there
could also be cash flows from investing8, from buying or selling assets. Free cash
6. Recurring cash flows that flow9 is the cash available to make investments or financing decisions after taking
result from income and care of operations and debt obligations. It is calculated as cash flow from operations
expense events. less debt repayments.
7. Nonrecurring cash flows that
result from the borrowing or
repayment of debt, or from the The most significant difference between the three categories of cash
issue or repurchase of equity. flows—operating, investing, or financing—is whether or not the cash flows may be
expected to recur regularly. Operating cash flows recur regularly; they are the cash
8. Nonrecurring cash flows that
result from buying or selling flows that result from income and expenses or consumption and therefore can be
assets. expected to occur in every year. Operating cash flows may be different amounts in
different periods, but they will happen in every period. Investing and financing
9. Income remaining after the
deduction of living expenses cash flows, on the other hand, may or may not recur and often are unusual events.
and debt obligations that is Typically, for example, you would not borrow or lend or buy or sell assets in every
available for capital
expenditures or investment.

year. Here is how Alice’s cash flows would be classified (Figure 3.7 "Alice’s Cash
Flow Statement for the Year 2009").
Figure 3.7 Alice’s Cash Flow Statement for the Year 2009
This cash flow statement more clearly shows how liquidity is created and where
liquidity could be increased. If Alice wanted to create more liquidity, it is obvious
that eliminating those loan payments would be a big help: without them, her net
cash flow would increase by more than 3,900 percent.
Balance Sheet
In business or in personal finance, a critical piece in assessing the current situation

is the balance sheet. Often referred to as the “statement of financial condition,” the
balance sheet10 is a snapshot of what you have and what you owe at a given point
in time. Unlike the income or cash flow statements, it is not a record of
performance over a period of time, but simply a statement of where things stand at
a certain moment.
The balance sheet is a list of assets, debts or liabilities, and equity or net worth, with
10. A list of all assets, liabilities, their values. In business, assets are resources that can be used to create income,
and equity or net worth, at a
given point in time, providing while debt and equity are the capital that financed those assets. Thus, the value of
a concise picture of financial the assets must equal the value of the debt and the equity. In other words, the value
condition at that time.

of the business’s resources must equal the value of the capital it borrowed or
bought in order to get those resources.
assets = liabilities + equity
In business, the accounting equation11 is as absolute as the law of gravity. It simply

must always be true, because if there are assets, they must have been financed
somehow—either through debt or equity. The value of that debt and equity
financing must equal or balance the value of the assets it bought. Thus, it is called
the “balance” sheet because it always balances the debt and equity with the value of
the assets.
In personal finance, assets are also things that can be sold to create liquidity.
Liquidity is needed to satisfy or repay debts. Because your assets are what you use
to satisfy your debts when they become due, the assets’ value should be greater
than the value of your debts. That is, you should have more to work with to meet
your obligations than you owe.
The difference between what you have and what you owe is your net worth12.
Literally, net worth is the share that you own of everything that you have. It is the
value of what you have net of (less) what you owe to others. Whatever asset value is
left over after you meet your debt obligations is your own worth. It is the value of
what you have that you can claim free and clear.
assets − debt = net worth
Your net worth is really your equity or financial ownership in your own life. Here,
too, the personal balance sheet must balance, because if
assets − debts = net worth,
then it should also be
11. Assets = liabilities + equity, or assets = debts + net worth.

the value of assets must be
equal to the value of the debt
and equity that financed them. Alice could write a simple balance sheet to see her current financial condition. She
In personal finance, assets =
has two assets (her car and her savings account), and she has two debts (her car and
debts + net worth, or net worth
= assets − debts. student loans) (Figure 3.8 "Alice’s Balance Sheet, December 31, 2009").
12. The value of assets owned after

creditors’ claims (debts) are
accounted for, or literally,
assets − debts.

Figure 3.8 Alice’s Balance Sheet, December 31, 2009
Alice’s balance sheet presents her with a much clearer picture of her financial
situation, but also with a dismaying prospect: she seems to have negative net worth.
Negative net worth13 results whenever the value of debts or liabilities is actually
greater than the assets’ value. If
liabilities < assets

then
assets − liabilities > 0;
net worth > 0 (net worth is positive)
If
liabilities > assets
then
assets − liabilities < 0;
net worth < 0 (net worth is negative)
Negative net worth implies that the assets don’t have enough value to satisfy the
debts. Since debts are obligations, this would cause some concern.
13. The mathematical result of Net Worth and Bankruptcy

liabilities being greater than
the value of assets, or debts
being larger than the value In business, when liabilities are greater than the assets to meet them, the business
that can be used to meet them. has negative equity and is literally bankrupt. In that case, it may go out of business,

selling all its assets and giving whatever it can to its creditors14 or lenders, who will
have to settle for less than what they are owed. More usually, the business
continues to operate in bankruptcy, if possible, and must still repay its creditors,
although perhaps under somewhat easier terms. Creditors (and the laws) allow
these terms because creditors would rather get paid in full later than get paid less
now or not at all.
In personal finance, personal bankruptcy15 may occur when debts are greater than
the value of assets. But because creditors would rather be paid eventually than
never, the bankrupt is usually allowed to continue to earn income in the hopes of
repaying the debt later or with easier terms. Often, the bankrupt is forced to
liquidate (sell) some or all of its assets.
Because debt is a legal as well as an economic obligation,

there are laws governing bankruptcies that differ from Figure 3.9
state to state in the United States and from country to
country. Although debt forgiveness was discussed in the
Old Testament, throughout history it was not
uncommon for bankrupts in many cultures to be put to
death, maimed, enslaved, or
imprisoned.BankruptcyData.com,
http://www.bankruptcydata.com/Ch11History.htm
(accessed January 19, 2009). The use of another’s © 2010 Jupiterimages
property or wealth is a serious responsibility, so debt is Corporation
a serious obligation.
However, Alice’s case is actually not as dismal as it

looks, because Alice has an “asset” that is not listed on her balance sheet, that is,
her education. It is not listed on her balance sheet because the value of her
education, like the value of any asset, comes from how useful it is, and its usefulness
has not happened yet, but will happen over her lifetime. It will happen in her
future, based on how she chooses to use her education to increase her income and
wealth. It is difficult to assign a monetary value to her education now. Alice knows
14. Lenders; anyone to whom debt
what she paid for her education, but, sensibly, its real value is not its cost but its
is owed.
potential return, or what it can earn for her as she puts it to use in the future.
15. An economic situation when
the value of debts is greater
than the value of the assets Current studies show that a college education has economic value, because a college
that can be used to satisfy graduate earns more over a lifetime than a high school graduate. Recent estimates
them. Formal bankruptcy is
also a legal process aiming to put that difference at about $1,000,000.Sandy Baum and Jennifer Ma, “Education
compensate creditors, Pays: The Benefits of Higher Education for Individuals and Society” (Princeton, NJ:
governed by the laws of the The College Board, 2007). So, if Alice assumes that her education will be worth
nation or state in which it
$1,000,000 in extra income over her lifetime, and she includes that asset value on
occurs.

her balance sheet, then it would look more like this (Figure 3.10 "Alice’s Balance
Sheet (revised), December 31, 2009"):
Figure 3.10 Alice’s Balance Sheet (revised), December 31, 2009
This looks much better, but it’s not sound accounting practice to include an
asset—and its value—on the balance sheet before it really exists. After all, education
generally pays off, but until it does, it hasn’t yet and there is a chance, however
slim, that it won’t for Alice. A balance sheet is a snapshot of one’s financial situation
at one particular time. At this particular time, Alice’s education has value, but its
amount is unknown.
It is easy to see, however, that the only thing that creates negative net worth for
Alice is her student loan. The student loan causes her liabilities to be greater than
her assets—and if that were paid off, her net worth would be positive. Given that
Alice is just starting her adult earning years, her situation seems quite reasonable.

KEY TAKEAWAYS
• Three commonly used financial statements are the income statement,

the cash flow statement, and the balance sheet.
• Results for a period are shown on the income statement and the cash
flow statement. Current conditions are shown on the balance sheet.
• The income statement lists income and expenses.
• The cash flow statement lists three kinds of cash flows: operating
(recurring), financing (nonrecurring), and investing (nonrecurring).
• The balance sheet lists assets, liabilities (debts), and net worth.
• Net worth = assets − debts.
• Bankruptcy occurs when there is negative net worth, or when debts are
greater than assets.

EXERCISES
1. Prepare a personal income statement for the past year, using the same
format as Alice’s income statement in this chapter. Include all relevant
categories of income and expenses. What does your income statement
tell you about your current financial situation? For example, where does
your income come from, and where does it go? Do you have a surplus of
income over expenses? If, so what are you doing with the surplus? Do
you have a deficit? What can you do about that? Which of your expenses
has the greatest effect on your bottom line? What is the biggest
expense? Which expenses would be easiest to reduce or eliminate? How
else could you reduce expenses? Realistically, how could you increase
your income? How would you like your income statement for the next
year to look?
2. Using the format for Alice’s cash flow statement, prepare your cash flow
statement for the same one-year period. Include your cash flows from all
sources in addition to your operating cash flows—the income and
expenses that appear on your income statement. What, if any, were the
cash flows from financing and the cash flows from investing? Which of
your cash flows are recurring, and which are nonrecurring? What does
your cash flow statement tell you about your current financial situation?
If you wanted to increase your liquidity, what would you try to change
about your cash flows?
3. Now prepare a balance sheet, again based on Alice’s form. List all your
assets, liabilities and debts, and your equity from all sources. What does
the balance sheet show about your financial situation at this moment in
time? What is your net worth? Do you have positive or negative net
worth at this time, and what does that mean? To increase your liquidity,
how would your balance sheet need to change? What would be the
relationship between your cash flow statement and your budget?
4. Read the CNNMoney.com article “How Much Are You Worth?” (October
3, 2003, by Les Christie, at http://money.cnn.com/2003/09/30/pf/
millionaire/networth/), and use the data and calculator to determine
your net worth. How does you net worth compare to that of other
Americans in your age and income brackets?
5. The Small Business Administration’s Personal Financial Statement
combines features of an income statement and a balance sheet. You
would fill out a similar form if you were applying for a personal or
business loan at bank or mortgage lender. Go to http://www.sba.gov/
sbaforms/sba413.pdf and compare and contrast the SBA form with the
statements you have already created for this chapter’s exercises.

3.2 Comparing and Analyzing Financial Statements
LEARNING OBJECTIVES
1. Explain the use of common-size statements in financial analysis.

2. Discuss the design of each common-size statement.
3. Demonstrate how changes in the balance sheet may be explained by
changes on the income and cash flow statements.
4. Identify the purposes and uses of ratio analysis.
5. Describe the uses of comparing financial statements over time.
Financial statements are valuable summaries of financial activities because they can
organize information and make it easier and clearer to see and therefore to
understand. Each one—the income statement, cash flow statement, and balance
sheet—conveys a different aspect of the financial picture; put together, the picture
is pretty complete. The three provide a summary of earning and expenses, of cash
flows, and of assets and debts.
Since the three statements offer three different kinds of information, sometimes it
is useful to look at each in the context of the others, and to look at specific items in
the larger context. This is the purpose of financial statement analysis: creating
comparisons and contexts to gain a better understanding of the financial picture.
Common-Size Statements
On common-size statements16, each item’s value is listed as a percentage of

another. This compares items, showing their relative size and their relative
significance (see Figure 3.11 "Common Common-Size Statements"). On the income
statement, each income and expense may be listed as a percentage of the total
income. This shows the contribution of each kind of income to the total, and thus
the diversification of income. It shows the burden of each expense on total income
or how much income is needed to support each expense.
On the cash flow statement, each cash flow can be listed as a percentage of total
positive cash flows, again showing the relative significance and diversification of
the sources of cash, and the relative size of the burden of each use of cash.
16. Financial statements where
each item’s value is listed as a
percentage of or in relation to
another value.
79
On the balance sheet, each item is listed as a percentage of total assets, showing the
relative significance and diversification of assets, and highlighting the use of debt
as financing for the assets.
Figure 3.11 Common Common-Size Statements
Common-Size Income Statement
Alice can look at a common-size income statement17 by looking at her expenses as

a percentage of her income and comparing the size of each expense to a common
denominator: her income. This shows her how much of her income,
proportionately, is used up for each expense (Figure 3.12 "Alice’s Common-Size
Income Statement for the Year 2009").
Figure 3.12 Alice’s Common-Size Income Statement for the Year 2009
17. An income statement that lists

each kind of revenue and each
expense as a percentage of
total revenues.
3.2 Comparing and Analyzing Financial Statements 80

Seeing the common-size statement as a pie chart makes the relative size of the
slices even clearer (Figure 3.13 "Pie Chart of Alice’s Common-Size Income Statement
for the Year 2009").
Figure 3.13 Pie Chart of Alice’s Common-Size Income Statement for the Year 2009
The biggest discretionary use of Alice’s wages is her rent expense, followed by food,
car expenses, and entertainment. Her income tax expense is a big use of her wages,
but it is unavoidable or nondiscretionary. As Supreme Court Justice Oliver Wendell
Holmes, Jr., said, “Taxes are what we pay for a civilized society.”U.S. Department of
the Treasury, http://www.treas.gov/education/faq/taxes/taxes-society.shtml
(accessed January 19, 2009). Ranking expenses by size offers interesting insight into
lifestyle choices. It is also valuable in framing financial decisions, pointing out
which expenses have the largest impact on income and thus on the resources for
making financial decisions. If Alice wanted more discretionary income to make
more or different choices, she can easily see that reducing rent expense would have
the most impact on freeing up some of her wages for another use.
Common-Size Cash Flow Statement
Looking at Alice’s negative cash flows as percentages of her positive cash flow (on
the cash flow statement), or the uses of cash as percentages of the sources of cash,
creates the common-size cash flows18. As with the income statement, this gives
Alice a clearer and more immediate view of the largest uses of her cash (Figure 3.14
"Alice’s Common-Size Cash Flow Statement for the Year 2009" and Figure 3.15 "Pie
Chart of Alice’s Common-Size Cash Flow Statement").
18. A cash flow statement that lists

each cash flow as a percentage
of total positive cash flows.

Figure 3.14 Alice’s Common-Size Cash Flow Statement for the Year 2009
Figure 3.15 Pie Chart of Alice’s Common-Size Cash Flow Statement
Again, rent is the biggest discretionary use of cash for living expenses, but debts
demand the most significant portion of cash flows. Repayments and interest
together are 30 percent of Alice’s cash—as much as she pays for rent and food.
Eliminating those debt payments would create substantial liquidity for Alice.

Common-Size Balance Sheet
On the balance sheet, looking at each item as a percentage of total assets allows for
measuring how much of the assets’ value is obligated to cover each debt, or how
much of the assets’ value is claimed by each debt (Figure 3.16 "Alice’s Common-Size
Balance Sheet, December 31, 2009").
Figure 3.16 Alice’s Common-Size Balance Sheet, December 31, 2009
This common-size balance sheet19 allows “over-sized” items to be more obvious.

For example, it is immediately obvious that Alice’s student loan dwarfs her assets’
value and creates her negative net worth.
Common-size statements allow you to look at the size of each item relative to a
common denominator: total income on the income statement, total positive cash
flow on the cash flow statement, or total assets on the balance sheet. The relative
size of the items helps you spot anything that seems disproportionately large or
small. The common-size analysis is also useful for comparing the diversification of
items on the financial statement—the diversification of incomes on the income
statement, cash flows on the cash flow statement, and assets and liabilities on the
balance sheet. Diversification reduces risk, so you want to diversify the sources of
income and assets you can use to create value (Figure 3.17 "Pie Chart of Alice’s
Common-Size Balance Sheet: The Assets").
19. A balance sheet that lists each

asset, liability, and equity as a
percentage of total assets.

Figure 3.17 Pie Chart of Alice’s Common-Size Balance Sheet: The Assets
For example, Alice has only two assets, and one—her car—provides 95 percent of
her assets’ value. If something happened to her car, her assets would lose 95
percent of their value. Her asset value would be less exposed to risk if she had asset
value from other assets to diversify the value invested in her car.
Likewise, both her income and her positive cash flows come from only one source,
her paycheck. Because her positive net earnings and positive net cash flows depend
on this one source, she is exposed to risk, which she could decrease by diversifying
her sources of income. She could diversify by adding earned income—taking on a
second job, for example—or by creating investment income. In order to create
investment income, however, she needs to have a surplus of liquidity, or cash, to
invest. Alice has run head first into Adam Smith’s “great difficulty”Adam Smith, The
Wealth of Nations (New York: The Modern Library, 2000), Book I, Chapter ix. (that it
takes some money to make money; see Chapter 2 "Basic Ideas of Finance").
Relating the Financial Statements
Common-size statements put the details of the financial statements in clear relief
relative to a common factor for each statement, but each financial statement is also

related to the others. Each is a piece of a larger picture, and as important as it is to

see each piece, it is also important to see that larger picture. To make sound
financial decisions, you need to be able to foresee the consequences of a decision, to
understand how a decision may affect the different aspects of the bigger picture.
For example, what happens in the income statement and cash flow statements is
reflected on the balance sheet because the earnings and expenses and the other
cash flows affect the asset values, and the values of debts, and thus the net worth.
Cash may be used to purchase assets, so a negative cash flow may increase assets.
Cash may be used to pay off debt, so a negative cash flow may decrease liabilities.
Cash may be received when an asset is sold, so a decrease to assets may create
positive cash flow. Cash may be received when money is borrowed, so an increase in
liabilities may create a positive cash flow.
There are many other possible scenarios and transactions, but you can begin to see
that the balance sheet at the end of a period is changed from what it was at the
beginning of the period by what happens during the period, and what happens
during the period is shown on the income statement and the cash flow statement.
So, as shown in the figure, the income statement and cash flow information, related
to each other, also relate the balance sheet at the end of the period to the balance
sheet at the beginning of the period (Figure 3.18 "Relationships Among Financial
Statements").
Figure 3.18 Relationships Among Financial Statements
The significance of these relationships becomes even more important when

evaluating alternatives for financial decisions. When you understand how the
statements are related, you can use that understanding to project the effects of
your choices on different aspects of your financial reality and see the consequences
of your decisions.

Ratio Analysis
Creating ratios is another way to see the numbers in relation to each other. Any
ratio shows the relative size of the two items compared, just as a fraction compares
the numerator to the denominator or a percentage compares a part to the whole.
The percentages on the common-size statements are ratios, although they only
compare items within a financial statement. Ratio analysis is used to make
comparisons across statements. For example, you can see how much debt you have
just by looking at your total liabilities, but how can you tell if you can afford the
debt you have? That depends on the income you have to meet your interest and
repayment obligations, or the assets you could use (sell) to meet those obligations.
Ratio analysis20 can give you the answer.
The financial ratios21 you use depend on the perspective you need or the
question(s) you need answered. Some of the more common ratios (and questions)
are presented in the following chart (Figure 3.19 "Common Personal Financial
Ratios").
Figure 3.19 Common Personal Financial Ratios
20. A way of comparing amounts

by creating ratios or fractions
that compare the amount in
the numerator to the amount
in the denominator.
21. Ratios used to understand

financial statement amounts
relative to each other.

These ratios all get “better” or show improvement as they get bigger, with two
exceptions: debt to assets and total debt. Those two ratios measure levels of debt,
and the smaller the ratio, the less the debt. Ideally, the two debt ratios would be less
than one. If your debt-to-assets ratio is greater than one, then debt is greater than
assets, and you are bankrupt. If the total debt ratio is greater than one, then debt is
greater than net worth, and you “own” less of your assets’ value than your creditors
do.
Some ratios will naturally be less than one, but the bigger they are, the better. For
example, net income margin will always be less than one because net income will
always be less than total income (net income = total income − expenses). The larger
that ratio is and the fewer expenses that are taken away from the total income, the
better.
Some ratios should be greater than one, and the bigger they are, the better. For
example, the interest coverage ratio should be greater than one, because you
should have more income to cover interest expenses than you have interest
expenses, and the more you have, the better. Figure 3.20 "Results of Ratio Analysis"
suggests what to look for in the results of your ratio analyses.
Figure 3.20 Results of Ratio Analysis

While you may have a pretty good “feel” for your situation just by paying the bills
and living your life, it so often helps to have the numbers in front of you. Here is
Alice’s ratio analysis for 2009 (Figure 3.21 "Alice’s Ratio Analysis, 2009").
Figure 3.21 Alice’s Ratio Analysis, 2009
The ratios that involve net worth—return-on-net-worth and total debt—are

negative for Alice, because she has negative net worth, as her debts are larger than
her assets. She can see how much larger her debt is than her assets by looking at
her debt-to-assets ratio. Although she has a lot of debt (relative to assets and to net
worth), she can earn enough income to cover its cost or interest expense, as shown
by the interest coverage ratio.
Alice is earning well. Her income is larger than her assets. She is able to live
efficiently. Her net income is a healthy 13.53 percent of her total income (net
income margin), which means that her expenses are only 86.47 percent of it, but
her cash flows are much less (cash flow to income), meaning that a significant
portion of earnings is used up in making investments or, in Alice’s case, debt
repayments. In fact, her debt repayments don’t leave her with much free cash flow;
that is, cash flow not used up on living expenses or debts.
Looking at the ratios, it is even more apparent how much—and how subtle—a
burden Alice’s debt is. In addition to giving her negative net worth, it keeps her
from increasing her assets and creating positive net worth—and potentially more
income—by obligating her to use up her cash flows. Debt repayment keeps her from
being able to invest.

Currently, Alice can afford the interest and the repayments. Her debt does not keep
her from living her life, but it does limit her choices, which in turn restricts her
decisions and future possibilities.
Comparisons over Time
Another useful way to compare financial statements is to look at how the situation
has changed over time. Comparisons over time provide insights into the effects of
past financial decisions and changes in circumstance. That insight can guide you in
making future financial decisions, particularly in foreseeing the potential costs or
benefits of a choice. Looking backward can be very helpful in looking forward.
Fast-forward ten years: Alice is now in her early thirties. Her career has progressed,
and her income has grown. She has paid off her student loan and has begun to save
for retirement and perhaps a down payment on a house.
A comparison of Alice’s financial statements shows the change over the decade,
both in absolute dollar amounts and as a percentage (see Figure 3.22 "Alice’s
Income Statements: Comparison Over Time", Figure 3.23 "Alice’s Cash Flow
Statements: Comparison Over Time", and Figure 3.24 "Alice’s Balance Sheets:
Comparison Over Time"). For the sake of simplicity, this example assumes that
neither inflation nor deflation have significantly affected currency values during
this period.
Figure 3.22 Alice’s Income Statements: Comparison Over Time

Figure 3.23 Alice’s Cash Flow Statements: Comparison Over Time
Figure 3.24 Alice’s Balance Sheets: Comparison Over Time
Starting with the income statement, Alice’s income has increased. Her income tax
withholding and deductions have also increased, but she still has higher disposable
income (take-home pay). Many of her living expenses have remained consistent;

rent and entertainment have increased. Interest expense on her car loan has
increased, but since she has paid off her student loan, that interest expense has
been eliminated, so her total interest expense has decreased. Overall, her net
income, or personal profit, what she clears after covering her living expenses, has
almost doubled.
Her cash flows have also improved. Operating cash flows, like net income, have
almost doubled—due primarily to eliminating the student loan interest payment.
The improved cash flow allowed her to make a down payment on a new car, invest
in her 401(k), make the payments on her car loan, and still increase her net cash
flow by a factor of ten.
Alice’s balance sheet is most telling about the changes in her life, especially her now
positive net worth. She has more assets. She has begun saving for retirement and
has more liquidity, distributed in her checking, savings, and money market
accounts. Since she has less debt, having paid off her student loan, she now has
positive net worth.
Comparing the relative results of the common-size statements provides an even

deeper view of the relative changes in Alice’s situation (Figure 3.25 "Comparing
Alice’s Common-Size Statements for 2009 and 2019: Income Statements", Figure
3.26 "Comparing Alice’s Common-Size Statements for 2009 and 2019: Cash Flow
Statements", and Figure 3.27 "Comparing Alice’s Common-Size Statements for 2009
and 2019: Balance Sheets").

Figure 3.25 Comparing Alice’s Common-Size Statements for 2009 and 2019: Income Statements

Figure 3.26 Comparing Alice’s Common-Size Statements for 2009 and 2019: Cash Flow Statements

Figure 3.27 Comparing Alice’s Common-Size Statements for 2009 and 2019: Balance Sheets
Although income taxes and rent have increased as a percentage of income, living
expenses have declined, showing real progress for Alice in raising her standard of
living: it now costs her less of her income to sustain herself. Interest expense has
decreased substantially as a portion of income, resulting in a net income or
personal profit that is not only larger, but is larger relative to income. More of her
income is profit, left for other discretionary uses.
The change in operating cash flows confirms this. Although her investing activities
now represent a significant use of cash, her need to use cash in financing
activities—debt repayment—is so much less that her net cash flow has increased
substantially. The cash that used to have to go toward supporting debt obligations
now goes toward building an asset base, some of which (the 401(k)) may provide
income in the future.
Changes in the balance sheet show a much more diversified and therefore much less
risky asset base. Although almost half of Alice’s assets are restricted for a specific
purpose, such as her 401(k) and Individual Retirement Account (IRA) accounts, she
still has significantly more liquidity and more liquid assets. Debt has fallen from ten
times the assets’ value to one-tenth of it, creating some ownership for Alice.

Finally, Alice can compare her ratios over time (Figure 3.28 "Ratio Analysis
Comparison").
Figure 3.28 Ratio Analysis Comparison
Most immediately, her net worth is now positive, and so are the return-on-net-
worth and the total debt ratios. As her debt has become less significant, her ability
to afford it has improved (to pay for its interest and repayment). Both her interest
coverage and free cash flow ratios show large increases. Since her net income
margin (and income) has grown, the only reason her return-on-asset ratio has
decreased is because her assets have grown even faster than her income.
By analyzing over time, you can spot trends that may be happening too slowly or
too subtly for you to notice in daily living, but which may become significant over
time. You would want to keep a closer eye on your finances than Alice does,
however, and review your situation at least every year.

KEY TAKEAWAYS
• Each financial statement shows a piece of the larger picture. Financial

statement analysis puts the financial statement information in context
and so in sharper focus.
• Common-size statements show the size of each item relative to a
common denominator.
• On the income statement, each income and expense is shown as a
percentage of total income.
• On the cash flow statement, each cash flow is shown as a percentage of
total positive cash flow.
• On the balance sheet, each asset, liability, and net worth is shown as a
percentage of total assets.
• The income and cash flow statements explain the changes in the balance
sheet over time.
• Ratio analysis is a way of creating a context by comparing items from
different statements.
• Comparisons made over time can demonstrate the effects of past
decisions to better understand the significance of future decisions.
• Financial statements should be compared at least annually.

EXERCISES
1. Prepare common-size statements for your income statement, cash flow

statement, and balance sheet. What do your common-size statements
reveal about your financial situation? How will your common-size
statements influence your personal financial planning?
2. Calculate your debt-to-income ratio and other ratios using the financial
tools at Biztech (http://www.usnews.com/usnews/biztech/tools/
modebtratio.htm). According to the calculation, are you carrying a
healthy debt load? Why, or why not? If not, what can you do to improve
your situation?
3. Read a PDF document of a 2006 article by Charles Farrell in the Financial
Planning Association Journal on “Personal Financial Ratios: An Elegant
Roadmap to Financial Health and Retirement” at
http://www.slideshare.net/Ellena98/fpa-journal-personal-financial-
ratios-an-elegant-road-map. Farrell focuses on three ratios: savings to
income, debt to income, and savings rate to income. Where, how, and
why might these ratios appear on the chart of Common Personal
Financial Ratios in this chapter?
4. If you increased your income and assets and reduced your expenses and
debt, your personal wealth and liquidity would grow. In My Notes or in
your personal financial journal, outline a general plan for how you
would use or allocate your growing wealth to further reduce your
expenses and debt, to acquire more assets or improve your standard of
living, and to further increase your real or potential income.

3.3 Accounting Software: An Overview
LEARNING OBJECTIVES
1. Identify the uses of personal finance software.

2. List the common features of personal financial software.
3. Demonstrate how actual financial calculations may be accomplished
using personal financial software.
4. Discuss how personal financial software can assist in your personal
financial decisions.
Many software products are available to help you organize your financial
information to be more useful in making financial decisions. They are designed to
make the record-keeping aspects of personal finance—the collection, classification,
and sorting of financial data—as easy as possible. The programs also are designed to
produce summary reports (e.g., income statements, cash flow statements, and
balance sheets) as well as many calculations that may be useful for various aspects
of financial planning. For example, financial planning software exists for managing
education and retirement savings, debt and mortgage repayment, and income and
expense budgeting.
Collecting the Data
Most programs have designed their data input to look like a checkbook, which is
what most people use to keep personal financial records. This type of user interface
is intended to be recognizable and familiar, similar to the manual record keeping
that you already do.
When you input your checkbook data into the program,

the software does the bookkeeping—creating the Figure 3.29
journals, ledgers, adjustments, and trial balances that
generations of people have done, albeit more tediously,
with parchment and quill or with ledger paper and
pencil. Most personal financial transactions happen as
cash flows through a checking account, so the
checkbook becomes the primary source of data.
98
More and more, personal transactions are done by

electronic transfer; that is, no paper changes hands, but © 2010 Jupiterimages
cash still flows to and from an account, usually a Corporation
checking account.
Data for other transactions, such as income from

investments or changes in investment value, are usually received from periodic
statements issued by investment managers, such as banks where you have savings
accounts; brokers or mutual fund companies that manage investments; or
employers’ retirement account statements.
Most versions of personal financial software allow you to download account

information directly from the source—your bank, broker, or employer—which saves
you from manually entering the data into the program. Aside from providing
convenience, downloading directly should eliminate human error in transferring
the data.
Reporting Results and Planning Ahead
All personal financial software produces the essential summary reports—the

income statement, cash flow statement, and balance sheet—that show the results of
financial activity for the period. Most will also report more specific aspects of
activities, such as listing all transactions for a particular income or expense.
Most will provide separate reports on activities that have some tax consequence,
since users always need to be aware of tax obligations and the tax consequences of
financial decisions. Some programs, especially those produced by companies that
also sell tax software, allow you to export data from your financial software to your
tax program, which makes tax preparation—or at least tax record keeping—easier.
In some programs, you need to know which activities are taxable and flag them as
such. Some programs recognize that information already, while others may still
prompt you for tax information.
All programs allow you to play “what if”: a marvelous feature of computing power
and the virtual world in general and certainly helpful when it comes to making
financial decisions. All programs include a budgeting feature that allows you to
foresee or project possible scenarios and gauge your ability to live with them. This
feature is particularly useful when budgeting for income and living expenses.
(Budgeting is discussed more thoroughly in Chapter 5 "Financial Plans: Budgets".)
Most programs have features that allow you to project the results of savings plans
for education or retirement. None can dictate the future, or allow you to, but they
can certainly help you to have a better view.
3.3 Accounting Software: An Overview 99

Security, Benefits, and Costs
All programs are designed to be installed on a personal computer or a handheld

device such as a Personal Digital Assistant (PDA) or smart phone, but some can also
be run from a Web site and therefore do not require a download. Product and
service providers are very concerned with security.
As with all Internet transactions, you should be aware that the more your data is
transferred, downloaded, or exported over the Internet, the more exposed it is to
theft. Personal financial data theft is a serious and growing problem worldwide, and
security systems are hard pressed to keep up with the ingenuity of hackers. The
convenience gained by having your bank, brokerage, tax preparer, and so on
accessible to you (and your data accessible to them) or your data accessible to you
wherever you are must be weighed against the increased exposure to data theft. As
always, the potential benefit should be considered against the costs.
Keeping digital records of your finances may be more secure than keeping them
scattered in shoeboxes or files, exposed to risks such as fire, flood, and theft. Digital
records are often easily retrievable because the software organizes them
systematically for you. Space is not a practical issue with digital storage, so records
may be kept longer. As with anything digital, however, you must be diligent about
backing up your data, although many programs will do that automatically or
regularly prompt you to do so. Hard copy records must be disposed of periodically,
and judging how long to keep them is always difficult. Throwing them in the trash
may be risky because of “dumpster diving,” a well-known method of identity theft,
so documents with financial information should always be shredded before
disposal.
Personal financial software is usually quite reasonably priced, with many programs
selling for less than $50, and most for less than $100. Buying the software usually
costs less than buying an hour of accounting expertise from an accountant or
financial planner. While software cannot replace financial planning professionals
who provide valuable judgment, it can allow you to hire them only for their
judgment and not have to pay them to collect, classify, sort, and report your
financial data.
Software will not improve your financial situation, but it can improve the
organization of your financial data monthly and yearly, allowing you a much
clearer view and almost certainly a much better understanding of your situation.

Software References
About.com offers general information
http://financialsoft.about.com/od/softwaretitle1/u/
Get_Started_Financial_Software.htm
Helpful software reviews
• http://financialsoft.about.com/od/reviewsfinancesoftware/
2_Financial_Software_Reviews.htm
• http://personal-finance-software-review.toptenreviews.com/
• http://blogs.zdnet.com/gadgetreviews/?p=432
• http://linux.com/feature/49400
• http://financialsoft.about.com/b/2008/04/09/updated-top-
personal-finance-software-for-mac-os.htm
Personal financial software favorites priced under $50 include
(as listed on http://personal-finance-software-review.toptenreviews.com/)
• Quicken
• Moneydance
• AceMoney
• BankTree Personal
• Rich Or Poor
• Budget Express
• Account Xpress
• iCash
• Homebookkeeping
• 3click Budget

KEY TAKEAWAYS
• Personal finance software provides convenience and skill for collecting,

classifying, sorting, reporting, and securing financial data to better
assess you current situation.
• To help you better evaluate your choices, personal finance

software provides calculations for projecting information such as
the following:
◦ Education savings
◦ Retirement savings
◦ Debt repayment
◦ Mortgage repayment
◦ Income and expense budgeting

EXERCISES
1. Explore free online resources for developing and comparing baseline

personal financial statements. One good resource is a blog from Money
Musings called “It’s Your Money” (http://www.mdmproofing.com/iym/
networth.shtml). This site also explains how and where to find the
figures you need for accurate and complete income statements and
balance sheets.
2. Compare and contrast the features of popular personal financial
planning software at the following Web sites: Mint.com,
Quicken.intuit.com, Moneydance.com, and Microsoft.com/Money. In My
Notes or your personal finance journal, record your findings. Which
software, if any, would be your first choice, and why? Share your
experience and views with others taking this course.
3. View these videos online and discuss with classmates your

answers to the questions that follow.
a. “Three Principles of Personal Finance” by the founder of

Mint: http://video.google.com/
videoplay?docid=6863995600686009715&ei=Ic1bSdyeF4rkqQL
tzIzrBg&q=personal+finance. What are the three principles of
personal finance described in this video? How is each
principle relevant to you and your personal financial
situation? What will be the outcome of observing the three
principles?
b. A financial planner explains what goes into a financial plan
in “How to Create a Financial Plan”:
http://www.youtube.com/watch?v=Wmhif6hmPTQ.
According to this video, what goes into a financial plan?
What aspects of financial planning do you already have in
place? What aspects of financial planning should you
consider next?
c. Certified Financial Planner (CFP) Board’s Financial Planning
Clinic, Washington, DC, October 2008:
http://www.youtube.com/watch?v=eJS5FMF_CFA. Each year
the Certified Financial Planner Board conducts a clinic in
which people can get free advice about all areas of financial
planning. This video is about the 2008 Financial Planning
Clinic in Washington, DC. What reasons or benefits did
people express about attending this event?

Chapter 4
Evaluating Choices: Time, Risk, and Value
Introduction
The land may vary more;

Figure 4.1
But wherever the truth may be—
The water comes ashore,
And the people look at the sea.
- Robert Frost, “Neither Out Far Nor In Deep”Robert

Frost, “Neither Out Far Nor In Deep,” Selected Poems of
Robert Frost (New York: Holt, Rinehart and Winston, © 2010 Jupiterimages
Inc., 1963). Corporation
Financial decisions can only be made about the future.

As much as analysis may tell us about the outcomes of
past decisions, the past is “sunk”: it can be known but not decided upon. Decisions
are made about the future, which cannot be known with certainty, so evaluating
alternatives for financial decisions always involves speculation on both the kind of
result and the value of the result that will occur. It also involves understanding and
measuring the risks or uncertainties that time presents and the opportunities—and
opportunity costs—that time creates.
104
Chapter 4 Evaluating Choices: Time, Risk, and Value
4.1 The Time Value of Money
LEARNING OBJECTIVES
1. Explain the value of liquidity.

2. Demonstrate how time creates distance, risk, and opportunity cost.
3. Demonstrate how time affects liquidity.
4. Analyze how time affects value.
Part of the planning process is evaluating the possible future results of a decision.
Since those results will occur some time from now (i.e., in the future), it is critical to
understand how time passing may affect those benefits and costs—not only the
probability of their occurrence, but also their value when they do. Time affects
value because time affects liquidity.
Liquidity is valuable, and the liquidity of an asset affects its value: all things being
equal, the more liquid an asset is, the better. This relationship—how the passage of
time affects the liquidity of money and thus its value—is commonly referred to as
the time value of money1, which can actually be calculated concretely as well as
understood abstractly.
Suppose you went to Mexico, where the currency is the peso. Coming from the
United States, you have a fistful of dollars. When you get there, you are hungry. You
see and smell a taco stand and decide to have a taco. Before you can buy the taco,
however, you have to get some pesos so that you can pay for it because the right
currency is needed to trade in that market. You have wealth (your fistful of dollars),
but you don’t have wealth that is liquid. In order to change your dollars into pesos
and acquire liquidity, you need to exchange currency. There is a fee to exchange
your currency: a transaction cost2, which is the cost of simply making the trade. It
also takes a bit of time, and you could be doing other things, so it creates an
1. The impact of the passing of opportunity cost (see Chapter 2 "Basic Ideas of Finance"). There is also the chance
time on the value of money, that you won’t be able to make the exchange for some reason, or that it will cost
based on the premise that
more than you thought, so there is a bit of risk involved. Obtaining liquidity for
being separated from liquidity
creates oportunity cost. your wealth creates transaction costs, opportunity costs, and risk.
2. The costs of achieving a trade

or “doing a deal” that do not
contribute to the value of the
thing being traded; a cost
created by making an
economic transaction.
105
In general, transforming not-so-liquid wealth into liquid

wealth creates transaction costs, opportunity costs, and Figure 4.2
risk, all of which take away from the value of wealth.
Liquidity has value because it can be used without any
additional costs.
One dimension of difference between not-so-liquid

wealth and liquidity is time. Cash flows (CF) in the past
are sunk, cash flows in the present are liquid, and cash
flows in the future are not yet liquid. You can only make
choices with liquid wealth, not with cash that you don’t
have yet or that has already been spent. Separated from
your liquidity and your choices by time, there is an Corporation
opportunity cost: if you had liquidity now, you could use
it for consumption or investment and benefit from it
now. There is also risk, as there is always some
uncertainty about the future: whether or not you will
actually get your cash flows and just how much they’ll be worth when you do.
The further in the future cash flows are, the farther away you are from your
liquidity, the more opportunity cost and risk you have, and the more that takes
away from the present value (PV) of your wealth, which is not yet liquid. In other
words, time puts distance between you and your liquidity, and that creates costs
that take away from value. The more time there is, the larger its effect on the value
of wealth.
Financial plans are expected to happen in the future, so financial decisions are
based on values some distance away in time. You could be trying to project an
amount at some point in the future—perhaps an investment payout or college
tuition payment. Or perhaps you are thinking about a series of cash flows that
happen over time—for example, annual deposits into and then withdrawals from a
retirement account. To really understand the time value of those cash flows, or to
compare them in any reasonable way, you have to understand the relationships
between the nominal or face values in the future and their equivalent, present
values (i.e., what their values would be if they were liquid today). The equivalent
present values today will be less than the nominal or face values in the future
because that distance over time, that separation from liquidity, costs us by
discounting those values.
4.1 The Time Value of Money 106

KEY TAKEAWAYS
• Liquidity has value because it enables choice.

• Time creates distance or delay from liquidity.
• Distance or delay creates risk and opportunity costs.
• Time affects value by creating distance, risk, and opportunity costs.
• Time discounts value.
EXERCISES
1. How does the expression “a bird in the hand is worth two in the bush”
relate to the concept of the time value of money?
2. In what four ways can “delay to liquidity” affect the value of your
wealth?
4.1 The Time Value of Money 107

4.2 Calculating the Relationship of Time and Value
LEARNING OBJECTIVES
1. Identify the factors you need to know to relate a present value to a

future value.
2. Write the algebraic expression for the relationship between present and
future value.
3. Discuss the use of the algebraic expression in evaluating the relationship
between present and future values.
4. Explain the importance of understanding the relationships among the
factors that affect future value.
Financial calculation is not often a necessary skill since it is easier to use

calculators, spreadsheets, and software. However, understanding the calculations is
important in understanding the relationships between time, risk, opportunity cost,
and value.
To do the math, you need to know
• what the future cash flows (CF) will be,

• when the future cash flows will be,
• the rate at which time affects value (e.g., the costs per time period, or
the magnitude [the size or amount] of the effect of time on value).
It is usually not difficult to forecast the timing and amounts of future cash flows.
Although there may be some uncertainty about them, gauging the rate at which
time affects money can require some judgment. That rate, commonly called the
discount rate3 because time discounts value, is the opportunity cost of not having
liquidity. Opportunity cost derives from forgone choices or sacrificed alternatives,
and sometimes it is not clear what those might have been (see Chapter 2 "Basic
Ideas of Finance"). It is an important judgment call to make, though, because the
rate will directly affect the valuation process.
3. The effect of time on value or

the rate at which time affects
value; used when calculating
the equivalent present value of
a nominal future value.
108
At times, the alternatives are clear: you could be putting

the liquidity in an account earning 3 percent, so that’s Figure 4.3
your opportunity cost of not having it. Or you are
paying 6.5 percent on a loan, which you wouldn’t be
paying if you had enough liquidity to avoid having to
borrow; so that’s your opportunity cost. Sometimes,
however, your opportunity cost is not so clear.
Say that today is your twentieth birthday. Your

grandparents have promised to give you $1,000 for your
twenty-first birthday, one year from today. If you had
the money today, what would it be worth? That is, how © 2010 Jupiterimages
much would $1,000 worth of liquidity one year from Corporation
now be worth today?
That depends on the cost of its not being liquid today, or

on the opportunity costs and risks created by not having liquidity today. If you had
$1,000 today, you could buy things and enjoy them, or you could deposit it in an
interest-bearing account. So on your twenty-first birthday, you would have more
than $1,000. You would have the $1,000 plus whatever interest it had earned. If your
bank pays 4 percent per year (interest rates are always stated as annual rates) on
your account, then you would earn $40 of interest in the next year, or $1,000 × .04.
So on your twenty-first birthday you would have $1,040.
$1,000 + (1,000 × 0.04) = $1,000 × (1 + 0.04) = $1,040
Figure 4.4
If you left that amount in the bank until your twenty-second birthday, you would
have
1,040 + (1,040 × 0.04) = 1,040 × (1 + 0.04)

= [1,000 × (1 + 0.04)] × (1 + 0.04)
= 1,000 × (1 + 0.04) 2 = 1,081.60.
4.2 Calculating the Relationship of Time and Value 109

To generalize the computation, if your present value4, or PV, is your value today, r
is the rate at which time affects value or discount rate (in this case, your interest
rate), and if t is the number of time periods between you and your liquidity, then
the future value5, or FV, of your wealth would be
Figure 4.5
PV × (1 + r)t = FV.
In this case,
1,000 × (1.04) 1 = 1,040 and 1,000 × (1.04) 2 = 1,081.60.
Assuming there is little chance that your grandparents will not be able to give this
gift, there is negligible risk. Your only cost of not having liquidity now is the
opportunity cost of having to delay consumption or not earning the interest you
could have earned.
The cost of delayed consumption is largely derived from a subjective valuation of

whatever is consumed, or its utility6 or satisfaction. The more value you place on
having something, the more it “costs” you not to have it, and the more the time
that you are without it affects its value.
4. Liquid value in the present, or
the discounted value of a Assuming that if you had the money today you would save it (as it’s much harder to
nominal amount of future
liquidity, taking into account quantify your joy from consumption), by having to wait to get it until your twenty-
the effect of time on value. first birthday—and not having it today—you miss out on $40 it could have earned.
5. The value of a present liquidity
or projected series of cash So, what would that nominal $1,000 (that future value that you get one year from
flows in the future, accounting
for the effects of time on value.
now) actually be worth today? The rate at which time affects your value is 4 percent
because that’s what having a choice (spend it or invest it) could earn for you if only
6. Value, including subjective or you had received the $1,000. That’s your opportunity cost. That’s what it costs you
nonmarket value as well as
objective or market value.
to not have liquidity. Since

PV × (1 + r)t = FV,
then
PV = FV/[(1 + r)t ],
so
PV = 1,000/(1.04 1 ) = 961.5385.
Your gift is worth $961.5385 today (its present value). If your grandparents offered
to give you your twenty-first birthday gift on your twentieth birthday, they could
give you $961.5385 today, which would be the equivalent value to you of getting
$1,000 one year from now.
It is important to understand the relationships between time, risk, opportunity

cost, and value. This equation describes that relationship:
PV × (1 + r)t = FV.
The “r” is more formally called the “discount rate” because it is the rate at which
your liquidity is discounted by time, and it includes not only opportunity costs but
also risk. (On some financial calculators, “r” is displayed as “I” or “i.”)
The “t” is how far away you are from your liquidity over time.
Studying this equation yields valuable insights into the relationship it describes.
Looking at the equation, you can observe the following relationships.
The more time (t) separating you from your liquidity, the more time affects value.
The less time separating you from your liquidity, the less time affects value (as t
decreases, PV increases).
As t increases the PV of your FV liquidity decreases
As t decreases the PV of your FV liquidity increases
The greater the rate at which time affects value (r), or the greater the opportunity
cost and risk, the more time affects value. The less your opportunity cost or risk,
the less your value is affected.
As r increases the PV of your FV liquidity decreases

As r decreases the PV of your FV liquidity increases
Figure 4.6 "Present Values, Interest Rates, Time, and Future Values" presents
examples of these relationships.
Figure 4.6 Present Values, Interest Rates, Time, and Future Values
The strategy implications of this understanding are simple, yet critical. All things
being equal, it is more valuable to have liquidity (get paid, or have positive cash
flow) sooner rather than later and give up liquidity (pay out, or have negative cash
flow) later rather than sooner.
If possible, accelerate incoming cash flows and decelerate outgoing cash flows: get
paid sooner, but pay out later. Or, as Popeye’s pal Wimpy used to say, “I’ll give you
50 cents tomorrow for a hamburger today.”

KEY TAKEAWAYS
• To relate a present (liquid) value to a future value, you need to

know
◦ what the present value is or the future value will be,

◦ when the future value will be,
◦ the rate at which time affects value: the costs per time
period, or the magnitude of the effect of time on value.
• The relationship of
◦ present value (PV),

◦ future value (FV),
◦ risk and opportunity cost (the discount rate, r), and
◦ time (t), may be expressed as
◦ PV × (1 + r)t = FV.
• The above equation yields valuable insights into these

relationships:
◦ The more time (t) creates distance from liquidity, the more
time affects value.
◦ The greater the rate at which time affects value (r), or the
greater the opportunity cost and risk, the more time affects
value.
◦ The closer the liquidity, the less time affects value.
◦ The less the opportunity cost or risk, the less value is
affected.
• To maximize value, get paid sooner and pay later.

EXERCISES
1. In My Notes or your financial planning journal, identify a future cash

flow. Calculate its present value and then calculate its future value based
on the discount rate and time to liquidity. Repeat the process for other
future cash flows you identify. What pattern of relationships do you
observe between time and value?
2. Try the Time Value of Money calculator at http://www.money-
zine.com/Calculators/Investment-Calculators/Time-Value-of-Money-
Calculator/. How do the results compare with your calculations in
Exercise 1?
3. View the TeachMeFinance.com animated audio slide show on “The Time
Value of Money” at http://teachmefinance.com/
timevalueofmoney.html. This slide show will walk you through an
example of how to calculate the present and future values of money.
How is each part of the formula used in that lesson equivalent to the
formula presented in this text?
4. To have liquidity, when should you increase positive cash flows and
decrease negative cash flows, and why?

4.3 Valuing a Series of Cash Flows
LEARNING OBJECTIVES
1. Discuss the importance of the idea of the time value of money in

2. Define the present value of a series of cash flows.
3. Define an annuity.
4. Identify the factors you need to know to calculate the value of an
annuity.
5. Discuss the relationships of those factors to the annuity’s value.
6. Define a perpetuity.
It is quite common in finance to value a series of future

cash flows (CF), perhaps a series of withdrawals from a Figure 4.7
retirement account, interest payments from a bond, or
deposits for a savings account. The present value (PV) of
the series of cash flows is equal to the sum of the
present value of each cash flow, so valuation is
straightforward: find the present value of each cash
flow and then add them up.
Often, the series of cash flows is such that each cash Corporation
flow has the same future value. When there are regular
payments at regular intervals and each payment is the
same amount, that series of cash flows is an annuity7.
Most consumer loan repayments are annuities, as are, typically, installment
purchases, mortgages, retirement investments, savings plans, and retirement plan
payouts. Fixed-rate bond interest payments are an annuity, as are stable stock
dividends over long periods of time. You could think of your paycheck as an
annuity, as are many living expenses, such as groceries and utilities, for which you
pay roughly the same amount regularly.
To calculate the present value of an annuity, you need to know
• the amount of the future cash flows (the same for each),
• the frequency of the cash flows,
7. A series of cash flows in which
equal amounts happen at • the number of cash flows (t),
regular, periodic intervals. • the rate at which time affects value (r).
115
Almost any calculator and the many readily available software applications can do
the math for you, but it is important for you to understand the relationships
between time, risk, opportunity cost, and value.
If you win the lottery, for example, you are typically offered a choice of payouts for
your winnings: a lump sum or an annual payment over twenty years.
The lottery agency would prefer that you took the annual payment because it would
not have to give up as much liquidity all at once; it could hold on to its liquidity
longer. To make the annual payment more attractive for you—it isn’t, because you
would want to have more liquidity sooner—the lump-sum option is discounted to
reflect the present value of the payment annuity. The discount rate, which
determines that present value, is chosen at the discretion of the lottery agency.
Say you win $10 million. The lottery agency offers you a choice: take $500,000 per
year over 20 years or take a one-time lump-sum payout of $6,700,000. You would
choose the alternative with the greatest value. The present value of the lump-sum
payout is $6,700,000. The value of the annuity is not simply $10 million, or $500,000
× 20, because those $500,000 payments are received over time and time affects
liquidity and thus value. So the question is, What is the annuity worth to you?
Your discount rate or opportunity cost will determine the annuity’s value to you, as
Figure 4.8 "Lottery Present Value with Different Discount Rates" shows.
4.3 Valuing a Series of Cash Flows 116

Figure 4.8 Lottery Present Value with Different Discount Rates
As expected, the present value of the annuity is less if your discount rate—or
opportunity cost or next best choice—is more. The annuity would be worth the
same to you as the lump-sum payout if your discount rate were 4.16 percent.
In other words, if your discount rate is about 4 percent or less—if you don’t have
more lucrative choices than earning 4 percent with that liquidity—then the annuity
is worth more to you than the immediate payout. You can afford to wait for that
liquidity and collect it over twenty years because you have no better choice. On the
other hand, if your discount rate is higher than 4 percent, or if you feel that your
use of that liquidity would earn you more than 4 percent, then you have more
lucrative things to do with that money and you want it now: the annuity is worth
less to you than the payout.
For an annuity, as when relating one cash flow’s present and future value, the
greater the rate at which time affects value, the greater the effect on the present
value. When opportunity cost or risk is low, waiting for liquidity doesn’t matter as
much as when opportunity costs or risks are higher. When opportunity costs are
low, you have nothing better to do with your liquidity, but when opportunity costs
are higher, you may sacrifice more by having no liquidity. Liquidity is valuable
because it allows you to make choices. After all, if there are no more valuable
choices to make, you lose little by giving up liquidity. The higher the rate at which

time affects value, the more it costs to wait for liquidity, and the more choices pass
you by while you wait for liquidity.
When risk is low, it is not really important to have your liquidity firmly in hand any
sooner because you’ll have it sooner or later anyhow. But when risk is high, getting
liquidity sooner becomes more important because it lessens the chance of not
getting it at all. The higher the rate at which time affects value, the more risk there
is in waiting for liquidity and the more chance that you won’t get it at all.
As r increases the PV of the annuity decreases
As r decreases the PV of the annuity increases
You can also look at the relationship of time and cash flow to annuity value.
Suppose your payout was more (or less) each year, or suppose your payout
happened over more (or fewer) years (Figure 4.9 "Lottery Payout Present Values").
Figure 4.9 Lottery Payout Present Values
As seen in Figure 4.9 "Lottery Payout Present Values", the amount of each payment
or cash flow affects the value of the annuity because more cash means more
liquidity and greater value.
As CF increases the PV of the annuity increases
As CF decreases the PV of the annuity decreases

Although time increases the distance from liquidity, with an annuity, it also
increases the number of payments because payments occur periodically. The more
periods in the annuity, the more cash flows and the more liquidity there are, thus
increasing the value of the annuity.
As t increases the PV of the annuity increases
As t decreases the PV of the annuity decreases
It is common in financial planning to calculate the FV of a series of cash flows. This

calculation is useful when saving for a goal where a specific amount will be required
at a specific point in the future (e.g., saving for college, a wedding, or retirement).
It turns out that the relationships between time, risk, opportunity cost, and value
are predictable going forward as well. Say you decide to take the $500,000 annual
lottery payout for twenty years. If you deposit that payout in a bank account
earning 4 percent, how much would you have in twenty years? What if the account
earned more interest? Less interest? What if you won more (or less) so the payout
was more (or less) each year?
What if you won $15 million and the payout was $500,000 per year for thirty years,
how much would you have then? Or if you won $5 million and the payout was only
for ten years? Figure 4.10 "Lottery Payout Future Values" shows how future values
would change.
Figure 4.10 Lottery Payout Future Values

Going forward, the rate at which time affects value (r) is the rate at which value
grows, or the rate at which your value compounds. It is also called the rate of
compounding8. The bigger the effect of time on value, the more value you will end
up with because more time has affected the value of your money while it was
growing as it waited for you. So, looking forward at the future value of an annuity:
As r increases the FV of the annuity increases
As r decreases the FV of the annuity decreases
The amount of each payment or cash flow affects the value of the annuity because
more cash means more liquidity and greater value. If you were getting more cash
each year and depositing it into your account, you’d end up with more value.
As CF increases the FV of the annuity increases
As CF decreases the FV of the annuity decreases
The more time there is, the more time can affect value. As payments occur
periodically, the more cash flows there are, the more liquidity there is. The more
periods in the annuity, the more cash flows, and the greater the effect of time, thus
increasing the future value of the annuity.
As t increases the FV of the annuity increases
As t decreases the FV of the annuity decreases
There is also a special kind of annuity called a perpetuity9, which is an annuity that
goes on forever (i.e., a series of cash flows of equal amounts occurring at regular
intervals that never ends). It is hard to imagine a stream of cash flows that never
ends, but it is actually not so rare as it sounds. The dividends from a share of
corporate stock are a perpetuity, because in theory, a corporation has an infinite
life (as a separate legal entity from its shareholders or owners) and because, for
many reasons, corporations like to maintain a steady dividend for their
shareholders.
8. The effect of time on value or The perpetuity represents the maximum value of the annuity, or the value of the
the rate at which time affects
value; used when calculating annuity with the most cash flows and therefore the most liquidity and therefore the
the equivalent future value of a most value.
present amount of liquidity.
9. An infinite annuity; a stream of

periodic cash flows that
continues indefinitely.

Life Is a Series of Cash Flows
Once you understand the idea of the time value of money, and of its use for valuing
a series of cash flows and of annuities in particular, you can’t believe how you ever
got through life without it. These are the fundamental relationships that structure
so many financial decisions, most of which involve a series of cash inflows or
outflows. Understanding these relationships can be a tool to help you answer some
of the most common financial questions about buying and selling liquidity, because
loans and investments are so often structured as annuities and certainly take place
over time.
Loans are usually designed as annuities, with regular periodic payments that
include interest expense and principal repayment. Using these relationships, you
can see the effect of a different amount borrowed (PVannuity), interest rate (r), or
term of the loan (t) on the periodic payment (CF).
For example, if you get a $250,000 (PV), thirty-year (t), 6.5 percent (r) mortgage, the
monthly payment will be $1,577 (CF). If the same mortgage had an interest rate of
only 5.5 percent (r), your monthly payment would decrease to $1,423 (CF). If it were
a fifteen-year (t) mortgage, still at 6.5 percent (r), the monthly payment would be
$2,175 (CF). If you can make a larger down payment and borrow less, say $200,000
(PV), then with a thirty-year (t), 6.5 percent (r) mortgage you monthly payment
would be only $1,262 (CF) (Figure 4.11 "Mortgage Calculations").
Figure 4.11 Mortgage Calculations
Note that in Figure 4.11 "Mortgage Calculations", the mortgage rate is the monthly
rate, that is, the annual rate divided by twelve (months in the year) or r ÷ 12, and
that t is stated as the number of months, or the number of years × 12 (months in the
year). That is because the mortgage requires monthly payments, so all the variables
must be expressed in units of months. In general, the periodic unit used is defined
by the frequency of the cash flows and must agree for all variables. In this example,
because you have monthly cash flows, you must calculate using the monthly
discount rate (r) and the number of months (t).

Saving to reach a goal—to provide a down payment on a house, or a child’s

education, or retirement income—is often accomplished by a plan of regular
deposits to an account for that purpose. The savings plan is an annuity, so these
relationships can be used to calculate how much would have to be saved each
period to reach the goal (CF), or given how much can be saved each period, how
long it will take to reach the goal (t), or how a better investment return (r) would
affect the periodic savings, or the time needed (t), or the goal (FV).
For example, if you want to have $1,000,000 (FV) in the bank when you retire, and
your bank pays 3 percent (r) interest per year, and you can save $10,000 per year
(CF) toward retirement, can you afford to retire at age sixty-five? You could if you
start saving at age eighteen, because with that annual saving at that rate of return,
it will take forty-seven years (t) to have $1,000,000 (FV). If you could save $20,000
per year (CF), it would only take thirty-one years (t) to save $1,000,000 (FV). If you
are already forty years old, you could do it if you save $27,428 per year (CF) or if you
can earn a return of at least 5.34 percent (r) (Figure 4.12 "Retirement Savings
Calculations").
Figure 4.12 Retirement Savings Calculations
As you can see, the relationships between time, risk, opportunity cost, and value are
some of the most important relationships you will ever encounter in life, and
understanding them is critical to making sound financial decisions.
Financial Calculations
Modern tools make it much easier to do the math. Calculators, spreadsheets, and
software have been developed to be very user friendly and widely available.
Financial calculators are designed for financial calculations and have the equations
relating the present and future values, cash flows, the discount rate, and time

embedded, for single amounts or for a series of cash flows, so that you can calculate
any one of those variables if you know all the others.
Personal finance software packages usually come with a planning calculator, which
is nothing more than a formula with these equations embedded, so that you can
find any one variable if you know the others. These tools are usually presented as a
“mortgage calculator” or a “loan calculator” or a “retirement planner” and are set
up to answer common planning questions such as “How much do I have to save
every year for retirement?” or “What will my monthly loan payment be?”
Spreadsheets also have the equations already designed

and readily accessible, as functions or as macros. There Figure 4.13
are also stand-alone software applications that may be
downloaded to a mobile device, such as a smartphone or
Personal Digital Assistant (PDA). They are useful in
answering planning questions but lack the ability to
store and track your situation in the way that a more
complete software package can.
The calculations are discussed here not so that you can Corporation
perform them, as you have many tools to choose from
that can do that more efficiently, but so that you can
understand them, and most importantly, so that you
can understand the relationships that they describe.

KEY TAKEAWAYS
• The idea of the time value of money is fundamental to financial

decisions.
• The present value of the series of cash flows is equal to the sum of the
present value of each cash flow.
• A series of cash flows is an annuity when there are regular payments at
regular intervals and each payment is the same amount.
• To calculate the present value of an annuity, you need to know
◦ the amount of the identical cash flows (CF),

◦ the frequency of the cash flows,
◦ the number of cash flows (t),
◦ the discount rate (r) or the rate at which time affects value.
• The calculation for the present value of an annuity yields

valuable insights.
◦ The more time (t), the more periods and the more periodic
payments, that is, the more cash flows, and so the more
liquidity and the more value.
◦ The greater the cash flows, the more liquidity and the more
value.
◦ The greater the rate at which time affects value (r) or the
greater the opportunity cost and risk or the greater the rate
of discounting, the more time affects value.
• The calculation for the future value of an annuity yields valuable

insights.
◦ The more time (t), the more periods and the more periodic
payments, that is, the more cash flows, and so the more
liquidity and the more value.
◦ The greater the cash flows, the more liquidity and the more
value.
◦ The greater the rate at which time affects value (r) or the
greater the rate of compounding, the more time affects
value.
• A perpetuity is an infinite annuity.

EXERCISES
1. In My Notes or in your financial planning journal, identify and record all

your cash flows. Which cash flows function as annuities or perpetuities?
Calculate the present value of each. Then calculate the future value.
Which cash flows give you the greatest liquidity or value?
2. How can you determine if a lump-sum payment or an annuity will have
greater value for you?
3. Survey and sample financial calculators listed at
http://www.dinkytown.net/, http://www.helpmefinancial.com/, and
http://www.financialcalculators.com. Which ones might prove
especially useful to you? What do you identify as the chief strengths and
weaknesses of using financial calculators?

4.4 Using Financial Statements to Evaluate Financial Choices
LEARNING OBJECTIVE
1. Define pro forma financial statements.

2. Explain how pro forma financial statements can be used to project
future scenarios for the planning process.
Now that you understand the relationship of time and value, especially looking
forward, you can begin to think about how your ideas and plans will look as they
happen. More specifically, you can begin to see how your future will look in the
mirror of your financial statements. Projected or pro forma financial statements10
can show the consequences of choices. To project future financial statements, you
need to be able to envision the expected results of all the items on them. This can be
difficult, for there can be many variables that may affect your income and expenses
or cash flows (CF), and some of them may be unpredictable. Predictions always
contain uncertainty, so projections are always, at best, educated guesses. Still, they
can be useful in helping you to see how the future may look.
We can glimpse Alice’s projected cash flow statements and balance sheets for each
of her choices, for example, and their possible outcomes. Alice can actually project
how her financial statements will look after each choice is followed.
When making financial decisions, it is helpful to be able to think in terms of their

consequences on the financial statements, which provide an order to our summary
of financial results. For example, in previous chapters, Alice was deciding how to
decrease her debt. Her choices were to continue to pay it down gradually as she
does now; to get a second job to pay it off faster; or to go to Vegas, hit it big (or lose
big), and eliminate her debt altogether (or wind up with even more). Alice can look
at the effects of each choice on her financial statements (Figure 4.14 "Potential
Effects on Alice’s Financial Statements")
10. Projected results for financial

statements in the future, given
assumptions about what will
happen in the meantime.
126
Figure 4.14 Potential Effects on Alice’s Financial Statements
Looking more closely at the actual numbers on each statement gives a much clearer
look at Alice’s situation. Beginning with the income statement, income will increase
if she works a second job or goes to Vegas and wins, while expenses will increase
(travel expense) if she goes to Vegas at all. Assume that her second job would bring
in an extra $20,000 income and that she could win or lose $100,000 in Vegas. Any
change in gross wages or winnings (losses) would have a tax consequence; if she
loses in Vegas, she will still have income taxes on her salary. Figure 4.15 "Alice’s Pro
Forma Income Statements" begins with Alice’s pro forma income statements.
4.4 Using Financial Statements to Evaluate Financial Choices 127

Figure 4.15 Alice’s Pro Forma Income Statements
While Vegas yields the largest increase in net income or personal profit if she wins,
it creates the largest decrease if she loses; it is clearly the riskiest option. The pro
forma cash flow statements (Figure 4.16 "Alice’s Pro Forma Cash Flow Statements")
reinforce this observation.

Figure 4.16 Alice’s Pro Forma Cash Flow Statements
If Alice has a second job, she will use the extra cash flow, after taxes, to pay down
her student loan, leaving her with a bit more free cash flow than she would have
had without the second job. If she wins in Vegas, she can pay off both her car loan
and her student loan and still have an increased free cash flow. However, if she
loses in Vegas, she will have to secure more debt to cover her losses. Assuming she
borrows as much as she loses, she will have a small negative net cash flow and no
free cash flow, and her other assets will have to make up for this loss of cash value.
So, how will Alice’s financial condition look in one year? That depends on how she
proceeds, but the pro forma balance sheets (Figure 4.17 "Alice’s Pro Forma Balance
Sheets") can give a glimpse.

Figure 4.17 Alice’s Pro Forma Balance Sheets
If Alice has a second job, her net worth increases but is still negative, as she has paid
down more of her student loan than she otherwise would have, but it is still larger
than her asset value. If she wins in Vegas, her net worth can be positive; with her
loan paid off entirely, her asset value will equal her net worth. However, if she loses
in Vegas, she will have to borrow more, her new debt quadrupling her liabilities and
decreasing her net worth by that much more.
A summary of the critical “bottom lines” from each pro forma statement (Figure
4.18 "Alice’s Pro Forma Bottom Lines") most clearly shows Alice’s complete picture
for each alternative.
Figure 4.18 Alice’s Pro Forma Bottom Lines
Going to Vegas creates the best and the worst scenarios for Alice, depending on
whether she wins or loses. While the outcomes for continuing or getting a second
job are fairly certain, the outcome in Vegas is not; there are two possible outcomes
in Vegas. The Vegas choice has the most risk or the least certainty.

The Vegas alternative also has strategic costs: if she loses, her increased debt and its
obligations—more interest and principal payments on more debt—will further delay
her goal of building an asset base from which to generate new sources of income. In
the near future, or until her new debt is repaid, she will have even fewer financial
choices.
The strategic benefit of the Vegas alternative is that if she wins, she can eliminate
debt, begin to build her asset base, and have even more choices (by eliminating debt
and freeing cash flow).
The next step for Alice would be to try to assess the probabilities of winning or of
losing in Vegas. Once she has determined the risk involved—given the
consequences now illuminated on the pro forma financial statements—she would
have to decide if she can tolerate that risk, or if she should reject that alternative
because of its risk.
KEY TAKEAWAY
Pro forma financial statements show the consequences of financial choices

in the context of the financial statements.
EXERCISES
1. What do pro forma financial statements show?

2. What are pro forma financial statements based on?
3. What are the strategic benefits of making financial projections on pro
forma statements?

4.5 Evaluating Risk
LEARNING OBJECTIVES
1. Explain the basic dynamics of probabilities.

2. Discuss how probabilities can be used to measure expected value.
3. Describe how probabilities can be used in financial projections.
4. Analyze expected outcomes of financial choices.
Risk affects financial decision making in mysterious ways, many of which are the
subject of an entire area of scholarship now known as behavioral finance. The study
of risk and the interpretation of probabilities are complex. In making financial
decisions, a grasp of their basic dynamics is useful. One of the most important to
understand is the idea of independence.
An independent event11 is one that happens by chance. It cannot be willed or

decided upon. The probability or likelihood of an independent event can be
measured, based on its frequency in the past, and that probability can be used to
predict whether it will recur. Independent events can be the result of complex
situations. They can be studied to see which confluence of circumstances or
conditions make them more or less likely or affect their probability. But an
independent event is, in the end, no matter how skillfully analyzed, a matter of
some chance or uncertainty or risk; it cannot be determined or chosen.
11. An event made neither more

nor less probable by the
occurrence of another event.
132
Alice can choose whether or not to go to Vegas, but she

cannot choose whether or not to win. Winning—or Figure 4.19
losing—is an independent event. She can predict her
chances, the probability, that she’ll win based on her
past experiences, her apparent skill and knowledge, and
the known odds of casino gambling (about which many
studies have been done and there is much knowledge
available). But she cannot choose to win; there is always
some uncertainty or risk that she will not.
The probability of any one outcome for an event is

always stated as a percentage of the total outcomes
possible. An independent or risky event has at least two
possible outcomes: it happens or it does not happen.
There may be more outcomes possible, but there are at
least two; if there were only one outcome possible, there © 2010 Jupiterimages
would be no uncertainty or risk about the outcome. Corporation
For example, you have a “50-50 chance” of “heads”

when you flip a coin, or a 50 percent probability. On
average “heads” comes up half the time. That probability is based on historic
frequency; that is, “on average” means that for all the times that coins have been
flipped, half the time “heads” is the result. There are only two possible outcomes
when you flip a coin, and there is a 50 percent chance of each. The probabilities of
each possible outcome add up to 100 percent, because there is 100 percent
probability that something will happen. In this case, half the time it is one result,
and half the time it is the other. In general, the probabilities of each possible
outcome—and there may be many—add to 100 percent.
Probabilities can be used in financial decisions to measure the expected result of an

independent event. That expectation is based on the probabilities of each outcome
and its result if it does occur. Suppose you have a little wager going on the coin flip;
you will win a dollar if it come up “heads” and you will lose a dollar if it does not
(“tails”). You have a 50 percent chance of $1.00 and a 50 percent chance of −$1.00.
Half the time you can expect to gain a dollar, and half the time you can expect to
lose a dollar. Your expectation of the average result, based on the historic
frequency or probability of each outcome and its actual result, is
(0.50 × 1.00) + (0.50 × −1.00) = 0.50 + −0.50 = 0, or

(probability heads × result heads ) + (probability tails × result tails )
4.5 Evaluating Risk 133

—note that the probabilityheads + the probabilitytails = 1 or 100%—because those are

all the possible outcomes. The expected result for each outcome is its probability or
likelihood multiplied by its result. The expected result or expected value12 for the
action, for flipping a coin, is its weighted average outcome, with the “weights”
being the probabilities of each of its outcomes.
If you get $1.00 every time the coin flips “heads” and it does so half the time, then
half the time you get a dollar, or you can expect overall to realize half a dollar or
$0.50 from flipping “heads.” The other half of the time, you can expect to lose a
dollar, so your expectation has to include the possibility of flipping “tails” with an
overall or average result of losing $0.50 or −$0.50. So you can expect 0.50 from one
outcome and −0.50 from the other: altogether, you can expect 0.50 + −0.50 or 0
(which is why “flipping coins” is not a popular casino game.)
The expected value (E(V)) of an event is the sum of each possible outcome’s
probability multiplied by its result, or
E(V) = Σ(pn × rn ),
where Σ means summation, p is the probability of an outcome, r is its result, and n is

the number of outcomes possible.
When faced with the uncertainty of an alternative that involves an independent

event, it is often quite helpful to be able to at least calculate its expected value.
Then, when making a decision, that expectation can be weighed against or
compared to those of other choices.
12. The weighted average result

for an event, or the value
expected, on average, given the
probabilities of each of its
possible outcomes.

For example, Alice has projected four possible outcomes

for her finances depending on whether she continues, Figure 4.20
gets a second job, wins in Vegas, or loses in Vegas, but
there are really only three choices: continue, second job,
or go to Vegas—since winning or losing are outcomes of
the one decision to go to Vegas. She knows, with little or
no uncertainty, how her financial situation will look if
she continues or gets a second job. To compare the
Vegas choice with the other two, she needs to predict
what she can expect from going to Vegas, given that she
may win or lose once there.
Alice can calculate the expected result of going to Vegas

if she knows the probabilities of its two outcomes,
winning and losing. Alice does a bit of research and has
a friend show her a few tricks and decides that for her © 2010 Jupiterimages
the probability of winning is 30 percent, which makes Corporation
the probability of losing 70 percent. (As there are only
two possible outcomes in this case, their probabilities
must add to 100 percent.) Her expected result in Vegas,
then, is
(0.30 × 100,000) + (0.70 × −100,000) = 30,000 + −70,000 = −40,000.
Using the same calculations, she can project the expected result of going to Vegas
on her pro forma financial statements (Figure 4.21 "Alice’s Expected Outcomes with
a 30 Percent Chance of Winning in Vegas"). Look at the effect on her bottom lines:
Figure 4.21 Alice’s Expected Outcomes with a 30 Percent Chance of Winning in Vegas
If she only has a 30 percent chance of winning in Vegas, then going there at all is
the worst choice for her in terms of her net income and net worth. Her net cash
flow (CF) actually seems best with the Vegas option, but that assumes she can

borrow to pay her gambling losses, so her losses don’t create net negative cash flow.
She does, however, create debt.
Alice can also calculate what the probability of winning would have to be to make it
a worthwhile choice at all, that is, to give her at least as good a result as either of
her other choices (Figure 4.22 "Alice’s Expected Outcomes to Make Vegas a
Competitive Choice").
Figure 4.22 Alice’s Expected Outcomes to Make Vegas a Competitive Choice
To be the best choice in terms of all three bottom lines, Alice would have to have a
78 percent chance of winning at Vegas.
Her net worth would still be negative, but all three bottom lines would be at least as
good or better than they would be with her other two choices. If Alice thought she
had at least a 78 percent chance of winning and could tolerate the risk that she
might not, Vegas would be a viable choice for her.
Those are two very big “ifs,” but by being able to project an expected value or result
for each of her choices, using the probabilities of each outcome for the choice with
uncertainty, Alice can at least measure and compare the choices.
Using probabilities to derive the expected value of a choice provides a way to

evaluate an alternative with uncertainty. It requires projecting the probabilities
and results of each possible outcome or independent event. It cannot remove the
uncertainty or the risk that independence presents, but it can at least provide a way
to measure and then compare with other measurable, certain or uncertain, choices.

KEY TAKEAWAYS
• Probabilities can be used in financial decisions to measure the expected

result of an independent event.
• The expected value for a choice may be figured as E(V) = Σ (p n × rn).
• Expected value can be weighed against or compared to the values of
other choices.
EXERCISES
1. How are probabilities used in financial decisions?

2. How can you calculate the expected values of financial alternatives?
3. Compared to her other two choices and her financial goals, should Alice
go to Vegas? Why, or why not?
4. Read the explanation of expected value and its application to poker
playing at CardsChat: The Worldwide Poker Community
(http://www.cardschat.com/poker-odds-expected-value.php). Alice
might have used similar information to calculate her chances of winning
at Vegas.

Chapter 5
Financial Plans: Budgets
Introduction
Seeing the value of reaching a goal is often much easier than seeing a way to reach
that goal. People often resolve to somehow improve themselves or their lives. But
while they are not lacking sincerity, determination, or effort, they nevertheless fall
short for want of a plan, a map, a picture of why and how to get from here to there.
Pro forma financial statements provide a look at the potential results of financial
decisions. They can also be used as a tool to plan for certain results. When projected
in the form of a budget1, figures become not only an estimated result but also an
actual strategy or plan, a map illustrating a path to achieve a goal. Later, when you
compare actual results to the original plan, you can see how shortfalls or successes
can point to future strategies.
Budgets are usually created with a specific goal in mind:

to cut living expenses, to increase savings, or to save for Figure 5.1
a specific purpose such as education or retirement.
While the need to do such things may be brought into
sharper focus by the financial statements, the budget
provides an actual plan for doing so. It is more a
document of action than of reflection.
As an action statement, a budget is meant to be

dynamic, a reconciliation of “facts on the ground” and
“castles in the air.” While financial statements are
summaries of historic reality, that is, of all that has
already happened and is “sunk,” budgets reflect the
current realities that define the next choices. A budget
should never be merely followed but should constantly
be revised to reflect new information. © 2010 Jupiterimages
Corporation
1. A projection of the financial

requirements and
consequences of a plan.
138
Chapter 5 Financial Plans: Budgets
5.1 The Budget Process
LEARNING OBJECTIVES
1. Trace the budget process.

2. Discuss the relationships of goals and behaviors.
3. Demonstrate the importance of conservatism in the budget process.
4. Show the importance of timing in the budget process.
The budget process is an infinite loop similar to the larger financial planning
process. It involves
• defining goals and gathering data;

• forming expectations and reconciling goals and data;
• creating the budget;
• monitoring actual outcomes and analyzing variances;
• adjusting budget, expectations, or goals;
• redefining goals.
139
Figure 5.2 The Budget Process
A review of your financial statements or your current financial condition—as well

as your own ideas about how you are and could be living—should indicate
immediate and longer-term goals. It may also point out new choices. For example,
an immediate goal may be to lower housing expense. In the short-term you could
look for an apartment with lower rent, but in the long run, it may be more
advantageous to own a home. This long-term goal may indicate a need to start a
savings plan for a down payment.
The process of creating a budget can be instructive. Creating a budget involves

projecting realistic behavior. Your assumptions may come from your actual past
behavior based on accurate records that you have gathered. If you have been using
personal finance software, it has been keeping those records for you; if not, a
thorough review of your checkbook and investment statements will reveal that
information. Financial statements are useful summaries of the information you
need to create a budget.
After formulating realistic expectations based on past behavior and current

circumstances, you still must reconcile your future behavior with your original
expectations. For example, you may recognize that greater sacrifices need to be
5.1 The Budget Process 140

made, or that you must change your behavior, or even that your goals are
unattainable and should be more realistic—perhaps based on less desirable choices.
On the other hand, this can be a process of happy discovery: goals may be closer or
require less sacrifice than you may have thought.
Whether it results in sobering dismay or ambitious joy,

the budget process is one of reconciling your financial Figure 5.3
realities to your financial dreams. How you finance your
life determines how you can live your life, so budgeting
is really a process of mapping out a life strategy. You
may find it difficult to separate the emotional and
financial aspects of your goals, but the more
successfully you can do so, the more successfully you
will reach your goals.
Corporation
A budget is a projection of how things should work out,
but there is always some uncertainty. If the actual
results are better than expected, if incomes are more or
expenses less, expectations can be adjusted upward as a
welcome accommodation to good fortune. On the other hand, if actual results are
worse than expected, if incomes are less or expenses more, not only the next budget
but also current living choices may have to be adjusted to accommodate that
situation. Those new choices are less than preferred or you would have chosen
them in your original plan.
To avoid unwelcome adjustments, you should be conservative2 in your

expectations so as to maximize the probability that your actual results will be
better than expected. Thus, when estimating, you would always underestimate the
income items and potential gains and overestimate the expense items and potential
losses.
2. In finance, an approach You will also need to determine a time period and frequency for your budget
preferred in all financial process: annually, monthly, or weekly. The timing will depend on how much
planning: overestimate financial activity you have and how much discipline or guidance you want your
expenses, losses, and the value
budget to provide. You should assess your progress at least annually. In general,
of liabilities and underestimate
incomes, gains, and the value you want to keep a manageable amount of data for any one period, so the more
of assets. This is based on the financial activity you have, the shorter your budget period should be. Since your
idea that any surprises should budget needs to be monitored consistently, you don’t want to be flooded with so
be advantageous. The use of
this word in finance and much data that monitoring becomes too daunting a task. On the other hand, you
accounting has absolutely no want to choose an ample period or time frame to show meaningful results. Choose a
relation to any political time period that makes sense for your quantity of data or level of financial activity.
associations that the word may
have gained in common usage.

KEY TAKEAWAYS
• A budget is a process that mirrors the financial planning process.

• The process of creating a budget can suggest goals, behaviors, and
limitations.
• For the budget to succeed, goals and behaviors must be reconciled.
• Budgets should be prepared conservatively:
◦ Overestimate costs.
◦ Underestimate earnings.
• The appropriate time period is one that is
◦ short enough to limit the amount of data,

◦ long enough to capture meaningful data.
EXERCISES
1. In My Notes or your financial planning journal, begin your budgeting

process by reviewing your short-term and long-term goals. What will it
take to achieve those goals? What limitations and opportunities do you
have for meeting them? Then gather your financial data and choose a
time period and frequency for checking your progress.
2. View the video “Making a Budget—1” from Expert Village at
http://www.youtube.com/watch?v=rd_gGHKz0F0. According to this
video, why is a budget so important in personal financial planning?
What kinds of problems can you resolve by manipulating your personal
budget? What kinds of goals can you attain through changes to your
personal budget?

5.2 Creating the Comprehensive Budget
LEARNING OBJECTIVES
1. Describe the components of the comprehensive budget and their

purposes.
2. Describe the components of an operating budget.
3. Discuss the sources of recurring income and expenses.
4. Identify the factors in the operating budgeting process.
5. Identify the factors in the capital budgeting process.
Gathering data and creating a budget—with some goals already in mind—are the
initial steps in the process. Understanding the format or shape of the budget will
help guide you to the kind of information you need. A comprehensive
budget3—that is, a budget covering all aspects of financial life—will include a
projection of recurring incomes and expenses and of nonrecurring expenditures.
(Nonrecurring income or “windfalls” should not be counted on or “budgeted for,”
conservatively.) Recurring incomes would be earnings from wages, interest, or
dividends. Recurring expenditures may include living expenses, loan repayments,
and regular savings or investment deposits. Nonrecurring expenditures may be for
capital improvements such as a new roof for your house or for purchases of durable
items such as a refrigerator or a car. These are purchases that would not be made
each period. A comprehensive budget diagram is shown in Figure 5.4
"Comprehensive Budget Diagram".
3. A budget that includes the

operating budget and the
capital budget, that is, it is
designed to show all aspects of
financial activities.
143
Figure 5.4 Comprehensive Budget Diagram
Another distinction in recognizing recurring and nonrecurring items is the time

frame for each. Recurring items need to be taken care of repeatedly and are
therefore considered in the short term, while the items on the capital budget may
allow for long-term planning because they happen less frequently. The different
time horizons for planning for recurring and nonrecurring items may allow for
different strategies to reach those different goals.
A comprehensive budget is a compilation of an operating budget4 for short-term

goals involving recurring items and a capital budget5 for long-term goals involving
nonrecurring items.
Operating Budget: Recurring Incomes and Expenditures

Using Financial History
Recurring incomes and expenditures are usually the easiest to determine and
project, as they happen consistently and have an immediate effect on your
4. The budget the shows everyday living. An income statement shows incomes and expenses; cash flow
recurring income and statements show actual cash expenditures. Recurring incomes and expenditures are
expenses, usually living
expenses and incomes from
planned in the context of short-term lifestyle goals or preferences.
wages, interest, and dividends,
usually related to short-term
financial goals. Look at a time period large enough to capture relevant data. Some incomes and
expenditures recur reliably but only periodically or seasonally. For example, you
5. The budget that shows
may pay the premium on your auto insurance policy twice per year. It is a recurring
nonrecurring events that are
usually associated with long- expense, but it happens in only two months of the year, so you would have to look
term financial goals. at expenditures over enough months to see it. Or your heating or cooling expenses
5.2 Creating the Comprehensive Budget 144

may change seasonally, affecting your utility expenses in some months more than
in others.
The time period you choose for a budget should be long enough to show
intermittent items as recurring and nonrecurring items as unusual, yet small
enough to follow and to manage choices within the period. For personal budgets, a
month is the most common budget period to use, since most living expenses are
paid at least monthly. However, it is best to use at least one full year’s worth of data
to get a reasonable monthly average and to see seasonal and periodic items as they
occur.
Some items may recur, but not reliably: either their frequency or their amount is
uncertain. Taking a conservative approach, you should include the maximum
possible amount of uncertain expenses in your budget. If income occurs regularly
but the amount is uncertain, conservatively include the minimum amount. If
income actually happens irregularly, it may be better just to leave it out of your
budget—and your plans—since you can’t “count” on it.
Consider the following example: Mark works as a school counselor, tutors on the
side, does house painting in the summer, and buys and sells sports memorabilia on
the Internet. In 2006, he bought an older house with a $200,000, fixed-rate mortgage
at 5.75 percent. Every year, he deposits $1,000 into his retirement account and uses
some capital for home improvements. He used a car loan to buy his car. Whatever
cash is left over after he has paid his bills is saved in a money market account that
earns 3 percent interest. At the end of 2009, Mark is trying to draw up a budget for
2010. Since he bought the house, he has been keeping pretty good financial records,
shown in Figure 5.5 "Mark’s Financial Data, 2006–2009".
Mark has five sources of income—some more constant, some more reliable, and
some more seasonal. His counseling job provides a steady, year-round paycheck.
House painting is a seasonal although fairly reliable source of income; in 2008 it was
less because Mark fell from a ladder and was unable to paint for two months.
Tutoring is a seasonal source of income, and since the school hired an additional
counselor in 2008, it has decreased. Memorabilia trading is a year-round but
unpredictable source of income. In 2009 he made some very lucrative trades, but in
2007 almost none. Interest income depends on the balance in the money market
account. He would include his counseling, painting, and interest incomes in his
budget, but should be conservative about including his tutoring or trading incomes.
Mark’s expenses are reliable and easily predictable, with a few exceptions. His
accident in 2008 increased his medical expenses for that year. Both gas for the car
and heating expense vary with the weather and the highly volatile price of oil; in

2008 those expenses were unusually high. Property tax increased in 2009 but is
unlikely to do so again for several years.
Figure 5.5 Mark’s Financial Data, 2006–2009
Using New Information and “Micro” Factors
Along with your known financial history, you would

Figure 5.6
want to include any new information that may change
your expectations. As with any forecast, the more
information you can include in your projections, the
more accurate it is likely to be.
Mark knows that the hiring of a new counselor has

significantly cut into his tutoring income and will likely
continue to do so. He will get a modest raise in his © 2010 Jupiterimages
wages, but has been notified that the co-pays and Corporation
deductibles on his medical and dental insurance will

increase in 2010. He has just traded in his car and gotten
a new loan for a “new” used car.

The personal or micro characteristics of your situation influence your expectations,

especially if they are expected to change. Personal factors such as family structure,
health, career choice, and age have significant influence on financial choices and
goals. If any of those factors is expected to change, your financial situation should
be expected to change as well, and that expectation should be included in your
budget projections.
For example, if you are expecting to increase or decrease the size of your family or
household, that would affect your consumption of goods and services. If you
anticipate a change of job or of career, that will affect your income from wages. A
change in health may result in working more or less and thus changing income
from wages. There are many ways that personal circumstances can change, and
they can change your financial expectations, choices, and goals. All these projected
changes need to be included in the budget process.
Using Economics and “Macro” Factors
Macro factors affecting your budget come from the context of the wider economy,
so understanding how incomes and expenses are created is useful in forming
estimates. Incomes are created when labor or capital (liquidity or assets) is sold.
The amount of income created depends on the quantity sold and on the price.
The price of labor depends on the relative supply and demand for labor reflected in
unemployment rates. The price of liquidity depends on the relative supply and
demand for capital reflected in interest rates. Unemployment rates and interest
rates in turn depend on the complex, dynamic economy.
The economy tends to behave cyclically. If the economy is in a period of contraction

or recession, demand for labor is lower, competition among workers is higher, and
wages cannot be expected to rise. As unemployment rises, especially if you are
working in an industry that is cyclically contracting with the economy, wages may
become unreliable or increasingly risky if there is risk of losing your job. Interest
rates are, as a rule, more volatile and thus more difficult to predict, but generally
tend to fall during a period of contraction and rise in a period of expansion. A
budget period is usually short so that economic factors will not vary widely enough
to affect projections over that brief period. Still, those economic factors should
inform your estimates of potential income.
Expenses are created when a quantity of goods or services is consumed for a price.
That price depends on the relative supply of and demand for those goods and
services and also on the larger context of price levels in the economy. If inflation or
deflation is decreasing or increasing the value of our currency, then its purchasing

power is changing and so is the real cost of expenses. Again, as a rule, the budget
period should be short enough so that changes in purchasing power won’t affect the
budget too much; still, these changes should not be ignored. Price levels are much
quicker to change than wage levels, so it is quite possible to have a rise in prices
before a rise in wages, which decreases the real purchasing power of your paycheck.
If you have a variable rate loan—that is, a loan for which the interest rate may be
adjusted periodically—you are susceptible to interest rate volatility. (This is
discussed at length in Chapter 16 "Owning Bonds".) You should be aware of that
particular macro factor when creating your budget.
Macroeconomic factors are difficult to predict, as they reflect complex scenarios,

but news about current and expected economic conditions is easily available in the
media every day. A good financial planner will also be keeping a sharp eye on
economic indicators and forecasts. You will have a pretty concrete idea of where
the economy is in its cycles and how that affects you just by seeing how your
paycheck meets your living expenses (e.g., filling up your car with gas or shopping
for groceries). Figure 5.7 "Factors for Determining a Projected Operating Budget
Item" suggests how personal history, microeconomic factors, and macroeconomic
factors can be used to make projections about items in your budget.
Figure 5.7 Factors for Determining a Projected Operating Budget Item
Using his past history, current information, and understanding of current and
expected macroeconomic factors, Mark has put together the budget shown in
Figure 5.8 "Mark’s 2010 Budget".

To project incomes, Mark relied on his newest information to estimate his wages
and tutoring income. He used the minimum income from the past four years for
memorabilia sales, which is conservative and reasonable given its volatility. His
painting income is less volatile, so his estimate is an average, excluding the unusual
year of his accident. Interest income is based on his current money market account
balance, which is adjusted for an expected drop in interest rates.
Mark expects his expenses to be what they were in 2009, since his costs and
consumption are not expected to change. However, he has adjusted his medical and
dental insurance and his car lease payments on the basis of his new knowledge.
The price of gas and heating oil has been extraordinarily volatile during this period
(2006–2009), affecting Mark’s gas and heating expense, so he bases his estimates on
what he knows about his expected consumption and the price. He knows he drives
an average of about 15,000 miles per year and that his car gets about 20 miles per
gallon. He estimates his gas expense for 2010 by guessing that since oil price levels
are about where they were in 2007, gas will cost, on average, what it did then, which
was $2.50 per gallon. He will buy, on average, 750 gallons per year (15,000 miles ÷ 20
mpg), so his total expense will be $1,875. Mark also knows that he uses 500 gallons
of heating oil each year. Estimating heating oil prices at 2007 levels, his cost will be
about the same as it was then, or $1,200.
Mark knows that the more knowledge and information he can bring to bear, the
more accurate and useful his estimates are likely to be.

Figure 5.8 Mark’s 2010 Budget
Capital Budget: Capital Expenditures and Investments
Income remaining after the deduction of living expenses and debt obligations, or
free cash flow6, is cash available for capital expenditures or investment. Capital
expenditures are usually part of a long-term plan of building an asset base.
Investment may also be part of a longer-term plan to build an asset base or to
achieve a specific goal such as financing education or retirement.
Long-term strategies are based on expected changes to the micro factors that shape
goals. For example, you want to save for retirement because you anticipate aging
and not being as willing or able to sell labor. Expanding or shrinking the family
structure may create new savings goals or a change in housing needs that will
indicate a change in asset base (e.g., buying or selling a house).
Some changes will eliminate a specific goal. A child finishing college, for example,
6. Income remaining after the
ends the need for education savings. Some changes will emphasize the necessity of
deduction of living expenses
and debt obligations that is a goal, such as a decline in health underscoring the need to save for retirement. As
available for capital personal factors change, you should reassess your longer-term goals and the capital
expenditures or investment.

expenditure toward those goals because long-term goals and thus capital
expenditures may change with them.
While many personal factors are relatively predictable over the long-term (e.g., you
will get older, not younger), the macroeconomic factors that will occur
simultaneously are much harder to predict. Will the economy be expanding or
contracting when you retire? Will there be inflation or deflation? The further (in
time) you are from your goals, the harder it is to predict those factors and the less
relevant they are to your budgeting concerns. As you get closer to your goals,
macro factors become more influential in the assessment of your goals and your
progress toward them.
Since long-term strategies happen over time, you

should use the relationships between time and value to Figure 5.9
calculate capital expenditures and progress toward
long-term goals. Long-term goals are often best reached
by a progression of steady and even steps; for example,
a saving goal is often reached by a series of regular and
steady deposits. Those regular deposits form an annuity.
Knowing how much time there is and how much
compounding there can be to turn your account balance
(the present value of this annuity) into your savings
goal (its future value), you can calculate the amount of
the deposits into the account. This can then be
compared to your projected free cash flow to see if such
a deposit is possible. You can also see if your goal is too © 2010 Jupiterimages
modest or too ambitious and should be adjusted in Corporation
terms of the time to reach a goal or the rate at which
you do.
Capital expenditures may be a one-time investment, like a new roof. A capital

expenditure may also be a step toward a long-term goal, like an annual savings
deposit. That goal should be assessed with each budget, and that “step” or capital
expenditure should be reviewed. Figure 5.10 "Factors for Determining the Projected
Capital Budget Item" shows the relationship of factors used to determine the capital
budget.

Figure 5.10 Factors for Determining the Projected Capital Budget Item
Mark’s 2010 budget (shown in Figure 5.8 "Mark’s 2010 Budget") projects a drop in
income and disposable income, and a rise in living expenses, leaving him with less
free cash flow for capital expenditures or investments. He knows that his house
needs a new roof (estimated cost = $15,000) and was hoping to have that done in
2010. However, that capital expenditure would create negative net cash flow, even if
he also uses the savings from his money market account. Mark’s budget shows that
both his short-term lifestyle preferences (projected income and expenses) and
progress toward his longer-term goals (property improvement and savings) cannot
be achieved without some changes and choices. What should those changes and
choices be?

KEY TAKEAWAYS
• A comprehensive budget consists of an operating budget and a capital

budget.
• The operating budget accounts for recurring incomes and expenses.
• Recurring incomes result from selling labor and/or liquidity.
• Recurring expenses result from consumption of goods and/or services.
• Recurring incomes and expenses
◦ satisfy short-term, lifestyle goals,

◦ create free cash flow for capital expenditures.
• The capital budget accounts for capital expenditures or nonrecurring
items.
• Capital expenditures are usually part of a longer-term plan or goal.
• Projecting recurring incomes and expenses involves using
◦ financial history,
◦ new information and microeconomic factors,
◦ macroeconomic factors.
• Different methods may be used to project different incomes and
expenses depending on the probability, volatility, and predictability of
quantity and price.
• Projecting capital expenditures involves using the following:
◦ New information and microeconomic factors

◦ Macroeconomic factors, although these are harder to predict
for a longer period, and therefore are less relevant
◦ The relationships described by the time value of money

EXERCISES
1. Using Mark’s budget sheet as a guide, adapt the budget categories and
amounts to reflect your personal financial realities and projections.
Develop an operating budget and a capital budget, distinguishing
recurring incomes and expenses from nonrecurring capital
expenditures. On what bases will you make projections about your
future incomes and expenses?
2. How does your budget sheet relate to your income statement, your cash
flow statement, and your balance sheet? How will you use this past
history to develop a budget to reach your short-term and long-term
goals?

5.3 The Cash Budget and Other Specialized Budgets
LEARNING OBJECTIVES
1. Discuss the use of a cash budget as a cash management tool.

2. Explain the cash budget’s value in clarifying risks and opportunities.
3. Explain the purpose of a specialized budget, including a tax budget.
4. Demonstrate the importance of including specialized budgets in the
comprehensive budget.
The Cash Budget
When cash flows are not periodic, that is, when they are affected by seasonality or a
different frequency than the budgetary period, a closer look at cash flow
management can be helpful. Although cash flows may be adequate to support
expenses for the whole year, there may be timing differences. Cash flows from
income may be less frequent than cash flows for expenses, for example, or may be
seasonal while expenses are more regular. Most expenses must be paid on a
monthly basis, and if some income cash flows occur less frequently or only
seasonally, there is a risk of running out of cash in a specific month. For cash flows,
timing is everything.
A good management tool is the cash budget, which is a rearrangement of budget

items to show each month in detail. Irregular cash flows can be placed in the
specific months when they will occur, allowing you to see the effects of cash flow
timing more clearly. Mark’s cash budget for 2010 is in the spreadsheet shown in
Figure 5.11 "Mark’s Cash Budget".
155
Figure 5.11 Mark’s Cash Budget
Mark’s original annual budget (Figure 5.8 "Mark’s 2010 Budget") shows that
although his income is enough to cover his living expenses, it does not produce
enough cash to support his capital expenditures, specifically, to fix the roof. In fact,
his cash flow would fall short by about $6,870, even after he uses the cash from his
savings (the money market account). If he must make the capital expenditure this
year, he can finance it with a line of credit7: a loan where money can be borrowed
as needed, up to a limit, and paid down as desired, and interest is paid only on the
outstanding balance. Using the line of credit, Mark would create an extra $321 of
interest expense for the year.
The cash budget (Figure 5.11 "Mark’s Cash Budget") shows a more detailed and
slightly different story. Because of Mark’s seasonal incomes, if he has the roof fixed
in May, he will need to borrow $10,525 in May (before he has income from
painting). Then he can pay that balance down until October, when he will need to
extend it again to pay his property tax. By the end of the year, his outstanding debt
7. A loan structured such that
money can be borrowed as will be a bit more than originally shown, with an ending balance of $6,887. But his
needed, up to a limit, and paid total interest expense will be a bit less—only $221—as the loan balance (and
down as desired, and interest is therefore the interest expense) will be less in some of the months that he has the
paid regularly but only on the
outstanding balance. loan.
5.3 The Cash Budget and Other Specialized Budgets 156

The cash (monthly) budget shows a different story than the annual budget because
of the seasonal nature of Mark’s incomes. Since he is planning the capital
expenditures before he begins to earn income from painting, he actually has to
borrow more—and assume more risk—than originally indicated.
The cash budget may show risks but also remedies that otherwise may not be
apparent. In Mark’s case, it is clear that the capital expenditure cannot be financed
without some external source of capital, most likely a line of credit. He would have
to pay interest on that loan, creating an additional expense. That expense would be
in proportion to the amount borrowed and the time it is borrowed for. In his
original plan the capital expenditure occurred in May, and Mark would have had to
borrow about $10,525, paying interest for the next seven months of the year.
Delaying the capital expenditure until October, however, would cost him less,
because he would have to borrow less and would be paying interest in fewer
months. An alternative cash budget illustrating this scenario is shown in Figure 5.12
"Mark’s Alternative Cash Budget".
Figure 5.12 Mark’s Alternative Cash Budget
Delaying the capital expenditure until October would also allow the money market
account to build value—Mark’s seasonal income would be deposited during the

summer—which would finance more of the capital expenditure. He could borrow

less, ending the year about $6,557 short, and his interest expense would be only
$123, because he has borrowed less and because he can wait until October to
borrow, thus paying interest for only three months of the year.
Timing matters for cash flows because you need to get cash before you spend it, but
also because time affects value, so it is always better to have liquidity sooner and
hang onto it longer. A cash budget provides a much more detailed look at these
timing issues, and the risks—and opportunities—of cash management that you may
otherwise have missed.
Other Specialized Budgets
A cash flow budget is a budget that projects a specific

Figure 5.13
aspect of your finances, that is, the cash flows. Other
kinds of specialized budgets8 focus on one particular
financial aspect or goal. A specialized budget is
ultimately included in the comprehensive budget, as it
is a part of total financial activity. It usually reflects one
particular activity in more detail, such as the effect of
owning and maintaining a particular asset or of
pursuing a particular activity. You create a budget for
that asset or that activity by segregating its incomes and
expenses from your comprehensive budget. It is
possible to create such a focused budget only if you can
identify and separate its financial activity from the rest
of your financial life. If so, you may want to track an
activity separately that is directly related to a specific
goal. © 2010 Jupiterimages
Corporation
For example, suppose you decide to take up weekend

backpacking as a recreational activity. You are going to
try it for two years, and then decide if you want to
continue. Aside from assessing the enjoyment that it gives you, you want to be able
to assess its impact on your finances. Typically, weekend backpacking requires
specialized equipment and clothing, travel to a hiking trail access or campground,
and perhaps lodging and meals: capital investment (in the equipment) and then
recurring expenses. You may want to create a separate budget for your backpacking
investment and expenses in order to assess the value of this new recreational
activity.
8. A budget that focuses on one
particular financial asset,
actvity, or goal.

One common type of specialized budget is a tax budget9, including

activities—incomes, expenses, gains, and losses—that have direct tax consequences.
A tax budget can be useful in planning for or anticipating an event that will have
significant tax consequences—for example, income from self-employment; the sale
of a long-term asset such as a stock portfolio, business, or real estate; or a gift of
significant wealth or the settling of an estate.
While it can be valuable to isolate and identify the effects of a specific activity or
the progress toward a specific goal, that activity or that goal is ultimately just a part
of your larger financial picture. Specialized budgets need to remain a part of your
comprehensive financial planning.
KEY TAKEAWAYS
• The cash flow budget is an alternative format used as a cash

management tool that provides
◦ more detailed information about the timing and amounts of

cash flows,
◦ a clearer view of risks and opportunities.
• Specialized budgets focus on a specific asset or activity.
• A tax budget is commonly used to track taxable activities.
• Eventually, specialized budgets need to be included in the
comprehensive budget to have a complete perspective.
EXERCISES
1. When is a cash flow budget a useful alternative to a comprehensive

budget?
2. Create a specialized budget and a tax budget from your comprehensive
budget.
9. A budget that focuses on the

tax consequences of projected
financial activities.

5.4 Budget Variances
LEARNING OBJECTIVES
1. Define and discuss the uses of budget variances.

2. Identify the importance of budget-monitoring activities.
3. Analyze budget variances to understand their causes, including possible
changes in micro or macro factors.
4. Analyze budget variances to see potential remedies and to gauge their
feasibility.
A budget variance10 occurs when the actual results of your financial activity differ
from your budgeted projections. Since your expectations were based on knowledge
from your financial history, micro- and macroeconomic factors, and new
information, if there is a variance, it is because your estimate was inaccurate or
because one or more of those factors changed unexpectedly. If your estimate was
inaccurate—perhaps you had overlooked or ignored a factor—knowing that can
help you improve. If one or more of those factors has changed unexpectedly, then
identifying the cause of the variance creates new information with which to better
assess your situation. At the very least, variances will alert you to the need for
adjustments to your budget and to the appropriate choices.
Once you have created a budget, your financial life continues. As actual data replace
projections, you must monitor the budget compared to your actual activities so that
you will notice any serious variances or deviations from the expected outcomes
detailed in the budget. Your analysis and understanding of variances constitute new
information for adjusting your current behavior, preparing the next budget, or
perhaps realistically reassessing your behavior or original goals.
The sooner you notice a budget variance, the sooner you can analyze it and, if
necessary, adjust for it. The sooner you correct the variance, the less it costs. For
example, perhaps you have had a little trouble living within your means, so you
have created a budget to help you do so. You have worked out a plan so that total
expenses are just as much as total income. In your original budget you expected to
have a certain expense for putting gas in your car, which you figured by knowing
the mileage that you drive and the current price of gas. You are following your
10. A difference between the budget and going along just fine. Suddenly, the price of gas goes way up. So does
actual results of your financial your monthly expense. That means you’ll have to
activity and your expected,
budgeted results.
160
• spend less for other expenses in order to keep your total expenses
within your budget,
• lower your gas expense by driving less, and/or
• increase your income to accommodate this larger expense.
In the short term, monitoring your gas expense alerts

you to a need to change your financial behavior by Figure 5.14
driving less, spending less on other things, or earning
more. In the long run, if you find this increased expense
intolerable, you will make other choices as well to avoid
it. Perhaps you would buy a more fuel-efficient car, for
example, or change your lifestyle to necessitate less
driving. The number and feasibility of your choices will
depend on your elasticity of demand for that particular
budget item. But if you hadn’t been paying attention, if
you had not been monitoring your budget against the
real outcomes that were happening as they were
happening, you would not have been aware that any
change was needed, and you would have found yourself
with a surprising budget deficit.
It bears repeating that once you have discovered a Corporation
significant budget variance, you need to analyze what
caused it so that you can address it properly.
Income results from the sale of labor (wages) or liquidity (interest or dividends). If
income deviates from its projection, it is because
• a different quantity of labor or liquidity was sold at the expected price

(e.g., you had fewer house painting contracts than usual but kept your
rates the same),
• the expected quantity of labor or liquidity was sold at a different price
(e.g., you had the usual number of contracts but earned less from
them), or
• a different quantity of labor or liquidity was sold at a different price
(e.g., you had fewer contracts and charged less to be more
competitive).
Expenses result from consuming goods or services at a price. If an expense deviates

from its projected outcome, it is because
5.4 Budget Variances 161

• a different quantity was consumed at the expected price (e.g., you did
not use as much gas),
• the expected quantity was consumed at a different price (e.g., you used
as much gas but the price of gas fell), or
• a different quantity was consumed at a different price (e.g., you used
less gas and bought it for less).
Isolating the cause of a variance is useful because different causes will dictate
different remedies or opportunities. For example, if your gas expense has increased,
is it because you are driving more miles or because the price of gas has gone up?
You can’t control the price of gas, but you can control the miles you drive. Isolating
the cause allows you to identify realistic choices. In this case, if the variance is too
costly, you will need to address it by somehow driving fewer miles.
If your income falls, is it because your hourly wage has fallen or because you are
working fewer hours? If your wage has fallen, you need to try to increase it either
by negotiating with your employer or by seeking a new job at a higher wage. Your
success will depend on demand in the labor market and on your usefulness as a
supplier of labor.
If you are working fewer hours, it may be because your employer is offering you less
work or because you choose to work less. If the problem is with your employer, you
may need to renegotiate your position or find a new one. However, if your employer
is buying less labor because of decreased demand in the labor market, that may be
due to an industry or economic cycle, which may affect your success in making that
change.
If it is your choice of hours that has caused the variance, perhaps that is due to
personal factors—you are aging or your dependents require more care and
attention—that need to be resolved to allow you to work more. Or perhaps you
could simply choose to work more.
Identifying why you are going astray from your budget is critical in identifying
remedies and choices. Putting those causes in the context of the micro- and
macroeconomic factors that affect your situation will make your feasible choices
clearer. Figure 5.15 "The Causes of a Budget Variance" shows how these factors can
combine to cause a variance.

Figure 5.15 The Causes of a Budget Variance
After three months, Mark decides to look at his budget variances to make sure he’s
on track. His actual results for January–March 2010 are detailed in Figure 5.16
"Mark’s Actual Income and Expenditures, January–March 2010".

Figure 5.16 Mark’s Actual Income and Expenditures, January–March 2010
How will Mark analyze the budget variances he finds? In Mark’s case, the income
variances are positive. He has picked up a couple of tutoring clients who have
committed to lessons through the end of the school year in June; this new
information can be used to adjust income. His memorabilia business has done well;
the volume of sales has not increased, but the memorabilia market seems to be up
and prices are better than expected. The memorabilia business is cyclical; economic
expansion and increases in disposable incomes enhance that market. Given the
volatility of prices in that market, however, and the fact that there has been no
increase in the volume of sales (Mark is not doing more business, just more
lucrative business), Mark will not make any adjustments going forward. Interest
rates have risen; Mark can use that macroeconomic news to adjust his expected
interest income.
His expenses are as expected. The only variance is the result of Mark’s decision to
cut his travel and entertainment budget for this year (i.e., giving up his vacation) to
offset the costs of the roof. He is planning that capital expenditure for October,
which (as seen in Figure 5.12 "Mark’s Alternative Cash Budget") will actually make
it cheaper to do. His adjusted cash budget is shown in Figure 5.17 "Mark’s Adjusted
Cash Budget for 2010".

Figure 5.17 Mark’s Adjusted Cash Budget for 2010
With these adjustments, it turns out that Mark can avoid new debt and still support
the capital expenditure of the new roof. The increased income that Mark can expect
and his decreased expenses (if he can maintain his resolve) can finance the project
and still leave him with a bit of savings in his money market account.
This situation bears continued monitoring, however. Some improvements are

attributable to Mark’s efforts (cutting back on entertainment expenses, giving up
his vacation, cultivating new tutoring clients). But Mark has also benefited from
macroeconomic factors that have changed to his advantage (rising interest rates,
rising memorabilia prices), and those factors could change again to his
disadvantage. He has tried to be conservative about making adjustments going
forward, but he should continue to keep a close eye on the situation, especially as
he gets closer to making the relatively large capital expenditure in October.
Sometimes a variance cannot be “corrected” or is due to a micro- or

macroeconomic factor beyond your control. In that case, you must adjust your
expectations to reality. You may need to adjust expected outcomes or even your
ultimate goals.

Variances are also measures of the accuracy of your projections; what you learn
from them can improve your estimates and your budgeting ability. The unexpected
can always occur, but the better you can anticipate what to expect, the more
accurate—and useful—your budget process can be.
KEY TAKEAWAYS
• Recognizing and analyzing variances between actual results and

budget expectations
◦ identifies potential problems,

◦ identifies potential remedies.
• The more frequently the budget is monitored, generally
◦ the sooner adjustments may be made,

◦ the less costly adjustments are to make.
• Budget variances for incomes and expenses should be analyzed

to see if they are caused by a difference in
◦ actual quantity,
◦ actual price,
◦ both actual quantity and actual price.
• Variances also need to be analyzed in the context of micro and macro
factors that may change.
EXERCISE
You are working fewer hours, which is reducing your income from
employment and causing a budget variance. If the choice is yours, what are
some microeconomic factors that could be causing this outcome? If the
choice is your employer’s, what are some macroeconomic factors that could
be sources of the variance? What are your choices for increasing income?
Alternatively, what might you change in your financial behavior, budget, or
goals to your improve outcomes?

5.5 Budgets, Financial Statements, and Financial Decisions
LEARNING OBJECTIVES
1. Describe the budget process as a financial planning tool.

2. Discuss the relationships between financial statements and budgets.
3. Demonstrate the use of budgets in assessing choices.
4. Identify factors that affect the value of choices.
Whatever type of budget you create, the budget process is one aspect of personal
financial planning, a tool to make better financial decisions. Other tools include
financial statements, assessments of risk and the time value of money,
macroeconomic indicators, and microeconomic or personal factors. The usefulness
of these tools is that they provide a clearer view of “what is” and “what is possible.”
It puts your current situation and your choices into a larger context, giving you a
better way to think about where you are, where you’d like to be, and how to go from
here to there.
Mark has to decide whether to go ahead with the new roof. Assuming the house
needs a new roof, his decision is really only about his choice of financing. An
analysis of Mark’s budget variances has shown that he can actually pay for the roof
with the savings in his money market account. This means his goal is more
attainable (and less costly) than in his original budget. This favorable outcome is
due to his efforts to increase income and reduce expenses and to macroeconomic
changes that have been to his advantage. So, Mark can make progress toward his
long-term goals of building his asset base. He can continue saving for retirement
with deposits to his retirement account and can continue improving his property
with a new roof on his house.
167
Because Mark is financing the roof with the savings

from his money market account, he can avoid new debt Figure 5.18
and thus additional interest expense. He will lose the
interest income from his money market account (which
is insignificant as it represents only 0.09 percent of his
total income), but the increases from his tutoring and
sales income will offset the loss. Mark’s income
statement will be virtually unaffected by the roof. His
cash flow statement will show unchanged operating
cash flow, a large capital expenditure, and use of
savings.
Mark can finance this increase of asset value (his new

roof) with another asset, his money market account. His
balance sheet will not change substantially—value will
just shift from one asset to another—but the money © 2010 Jupiterimages
market account earns income, which the house does Corporation
not, although there may be a gain in value when the
house is sold in the future.
Right now that interest income is insignificant, but since it seems to be a period of
rising interest rates, the opportunity cost of forgone interest income could be
significant in the future if that account balance were allowed to grow.
Moreover, Mark will be moving value from a very liquid money market account to a
not-so-liquid house, decreasing his overall liquidity. Looking ahead, this loss of
liquidity could create another opportunity cost: it could narrow his options. Mark’s
liquidity will be pretty much depleted by the roof, so future capital expenditures
may have to be financed with debt. If interest rates continue to rise, that will make
financing future capital expenditures more expensive and perhaps will cause Mark
to delay those expenditures or even cancel them.
However, Mark also has a very reliable source of liquidity in his earnings—his
paycheck, which can offset this loss. If he can continue to generate free cash flow to
add to his savings, he can restore his money market account and his liquidity.
Having no dependents makes Mark more able to assume the risk of depleting his
liquidity now and relying on his income to restore it later.
11. A difference between two
interest rates, quoted in basis
points. The most commonly The opportunity cost of losing liquidity and interest income will be less than the
noted spreads are those
cost of new debt and new interest expense. That is because interest rates on loans
between Treasury and
corporate securities of the are always higher than interest rates on savings. Banks always charge more than
same maturity. they pay for liquidity. That spread11, or difference between those two rates, is the
5.5 Budgets, Financial Statements, and Financial Decisions 168

bank’s profit, so the bank’s cost of buying money will always be less than the price
it sells for. The added risk and obligation of new debt could also create opportunity
cost and make it more difficult to finance future capital expenditures. So financing
the capital expenditure with an asset rather than with a liability is less costly both
immediately and in the future because it creates fewer obligations and more
opportunities, less opportunity cost, and less risk.
The budget and the financial statements allow Mark to project the effects of this
financial decision in the larger context of his current financial situation and
ultimate financial goals. His understanding of opportunity costs, liquidity, the time
value of money, and of personal and macroeconomic factors also helps him evaluate
his choices and their consequences. Mark can use this decision and its results to
inform his next decisions and his ultimate horizons.
Financial planning is a continuous process of making financial decisions. Financial

statements and budgets are ways of summarizing the current situation and
projecting the outcomes of choices. Financial statement analysis and budget
variance analysis are ways of assessing the effects of choices. Personal factors,
economic factors, and the relationships of time, risk, and value affect choices as
their dynamics—how they work and bear on decisions—affect outcomes.
KEY TAKEAWAYS
• Financial planning is a continuous process of making financial decisions.

• Financial statements are ways of summarizing the current situation.
• Budgets are ways of projecting the outcomes of choices.
• Financial statement analysis and budget variance analysis are ways of
assessing the effects of choices.
• Personal factors, economic factors, and the relationships of time, risk,
and value affect choices, as their dynamics affect outcomes.

EXERCISE
Analyze Mark’s budget as a financial planning tool for making decisions in

the following situations. In each case, how will other financial planning tools
affect Mark’s decisions? For each case, create a new budget showing the
projected effects of Mark’s decisions.
1. Mark injures himself on the cross-trainer, and the doctor recommends a

course of physical therapy.
2. A neighbor and coworker suggest that he and Mark commute to work
together.
3. The roofers inform Mark that his chimney needs to be repointed and
relined.
4. Mark wants to give up tutoring and put more time into his memorabilia
business.
5. Mark wants to marry and start a family and needs to know when would
be a good time.

Chapter 6
Taxes and Tax Planning
Introduction
All developed and most less-developed economies have a tax system that finances
their governments, at least in part. The design of that tax system reflects the
society’s view of the responsibilities of government and of its citizens for their
government.
In the United States there has always been disagreement about the role of
government as a producer for and a protector of the economy and its citizens. Even
before the United States was a nation, “taxation without representation” was a
rallying cry for rebellion against the British colonial authority, and the colonists
protested taxes on everything from stamps to tea. The American Revolution was as
much about economic democracy—the fundamental right of every individual to
participate in the economy and to own the fruits of labor—as it was about political
democracy.
It is perhaps no coincidence that Adam Smith’s Wealth of Nations was published in

1776, the same year that independence was declared in the thirteen colonies. Smith
recognized a role for government in a market-based economy, but societies have
argued about what that role should be and how it should be paid for ever since. The
U.S. tax code is based on the idea that everyone should help finance the
government according to one’s ability to pay. Changes in how “everyone” is defined
and how “ability to pay” is measured have led to tax law changes that keep the
system evolving.
In the United States, tax laws are written by Congress and therefore through
compromise. As views on government financing have changed, tax laws have been
amended and refined, enacted and repealed. The result is a tax code that can seem
overly complex and even unreasonable or illogical. However, the system is based on
logic and has a purpose. The better you understand the elements of the tax system,
the better you will understand how to live with it—and plan for it—to your best
advantage.
171
Chapter 6 Taxes and Tax Planning
6.1 Sources of Taxation and Kinds of Taxes
LEARNING OBJECTIVES
1. Identify the levels of government that impose taxes.

2. Define the different kinds of incomes, assets, and transactions that may
be taxed.
3. Compare and contrast progressive and regressive taxes.
Any government that needs to raise revenue and has the legal authority to do so
may tax. Tax jurisdictions reflect government authorities. In the United States,
federal, state, and municipal governments impose taxes. Similarly, in many
countries there are national, provincial or state, county, and municipal taxes.
Regional economic alliances, such as the European Union, may also levy taxes.
Jurisdictions may overlap. For example, in the United

States, federal, state, and local governments may tax Figure 6.1
income, which becomes complicated for those earning
income in more than one state, or living in one state
and working in another. Governments tax income
because it is a way to tax broadly based on the ability to
pay. Most adults have an income from some source,
even if it is a government distribution. Those with
higher incomes should be able to pay more taxes, and in
theory should be willing to do so, for they have been
more successful in or have benefited more from the © 2010 Jupiterimages
economy that the government protects. Corporation
Income tax is usually a progressive tax1: the higher the

income or the more to be taxed, the greater the tax rate.
The percentage of income that is paid in tax increases as income rises. Those
income categories are called tax brackets2 (Figure 6.2 "U.S. Income Tax Brackets in
2008 (Single Filing Status)").
1. A tax rate that increases as the

amount to be taxed increases, a
common design of an income
tax.
2. A range of income that defines

an income tax rate.
172
Figure 6.2 U.S. Income Tax Brackets in 2008 (Single Filing Status)
Source: http://www.moneychimp.com/features/tax_brackets.htm
Tax is levied on income from many sources:
• Wages (selling labor)

• Interest, dividends, and gains from investment (selling capital)
• Self-employment (operating a business or selling a good or service)
• Property rental
• Royalties (rental of intellectual property)
• “Other” income such as alimony, gambling winnings, or prizes
A sales tax or consumption tax3 taxes the consumption financed by income. In the
United States, sales taxes are imposed by state or local governments; as yet, there is
no national sales tax. Sales taxes are said to be more efficient and fair in that
consumption reflects income (income determines ability to consume and therefore
level of consumption). Consumption also is hard to hide, making sales tax a good
3. A sales or excise tax that taxes
the consumption of way to collect taxes based on the ability to pay. Consumption taxes typically tax all
discretionary and consumption, including nondiscretionary items such as food, clothing, and housing.
nondiscretionary goods and Opponents of sales tax argue that it is a regressive tax4, because those with lower
services.
incomes must use a higher percentage of their incomes on nondiscretionary
4. A tax rate that decreases as the purchases than higher-income people do.
amount to be taxed increases.
5. A consumption tax that The value-added tax5 (VAT) or goods and services tax (GST) is widely used outside
spreads the tax burden among
producers and consumers by the United States. It is a consumption tax, but differs from the sales tax, which is
taxing the value added to paid only by the consumer as an end user. With a VAT or GST, the value added to
goods at each stage of the product is taxed at each stage of production. Governments use a VAT or GST
production and consumption.
6.1 Sources of Taxation and Kinds of Taxes 173

instead of a sales tax to spread the tax burden among producers and consumers,
and thus to reduce incentive to evade the tax. A consumption tax, like the sales tax,
it is a regressive tax. When traveling abroad, you should be aware that a VAT may
add substantially to the cost of a purchase (a meal, accommodations, etc.).
Excise taxes6 are taxes on specific consumption items such as alcohol, cigarettes,
motor vehicles, fuel, or highway use. In some states, excise taxes are justified by the
discretionary nature of the purchases and may be criticized as exercises in social
engineering (i.e., using the tax code to dictate social behaviors). For example,
people addicted to nicotine or alcohol tend to purchase cigarettes or liquor even if
an excise tax increases their cost—and are therefore a reliable source of tax
revenue.
Property taxes are used by more local—state, municipal, provincial, and

county—governments, and are most commonly imposed on real property (land and
buildings) but also on personal assets such as vehicles and boats. Property values
theoretically reflect wealth (accrued income) and thus ability to pay taxes. Property
values are also a matter of public record (real property is deeded, boats or
automobiles are licensed), which allows more efficient tax collection.
Estate taxes7 are taxes on the transfer of wealth from the deceased to the living.
Estate taxes are usually imposed on the very wealthiest based on their unusual
ability to pay. Because death and the subsequent dispersal of property is legally a
matter of public record, estate taxes are generally easy to collect. Estate taxes are
controversial because they can be seen as a tax on the very idea of ownership and
on incomes that have already been taxed and saved or stored as wealth and
properties. Still, estate taxes are a substantial source of revenue for the
governments that use them, and so they remain.
A summary of the kinds of taxes used by the three different jurisdictions is shown
in Figure 6.3 "Taxes and Jurisdictions".
6. A tax on a specific item

produced within a country.
7. A tax on the intergenerational

transfer of wealth after death.

Figure 6.3 Taxes and Jurisdictions

KEY TAKEAWAYS
• Governments at all levels use taxes as a source of financing.
• Taxes may be imposed on the following:
◦ Incomes from
▪ wages,
▪ interest, dividends, and gains (losses),
▪ rental of real or intellectual property.
◦ Consumption of discretionary and nondiscretionary goods
and services.
◦ Wealth from
▪ asset ownership,
▪ asset transfer after death.
• Taxes may be
◦ progressive, such as the income tax, in which you pay

proportionally more taxes the more income you have;
◦ regressive, such as a sales tax, in which you pay
proportionally more taxes the less income you have.

EXERCISES
1. Examine your state, federal, and other tax returns that you filed last
year. Alternatively, estimate based on your present financial situation.
On what incomes were you (or would you be) taxed? What tax bracket
were you (or would you be) in? How did (or would) your state, federal,
and other tax liabilities differ? What other types of taxes did you (or
would you) pay and to which government jurisdictions?
2. Match the description to the type of tax. (Write the number of

the tax type before its description.)
◦ Description:
a. ________ tax on the use of vehicles, gasoline,

alcohol, cigarettes, highways, and the like.
b. ________ tax on the wealth and property of a
person upon death.
c. ________ tax on purchases of both discretionary
and nondiscretionary items.
d. ________ tax on wages, earned interest, capital
gain, and the like.
e. ________ tax on home and land ownership.
f. ________ tax on purchases of discretionary items.
g. ________ tax on items during their production as
well as upon consumption.
◦ Type of Tax:
1. Property tax
2. Consumption tax
3. Value-added or goods and services tax
4. Income tax
5. Excise tax
6. Sales tax
7. Estate tax
3. In My Notes or your financial planning journal, record all the types of

taxes you will be paying next year and to whom. How will you plan for
paying these taxes? How will your tax liabilities affect your budget?
4. According to the MSN Money Central article “8 Types of Income the IRS
Can’t Touch” (Jeff Schnepper, November 2009, at

http://articles.moneycentral.msn.com/Taxes/CutYourTaxes/
8typesOfIncomeTheIRScantTouch.aspx), what are eight sources of
income that the federal government cannot tax? Poll classmates on the
question of whether they think student income can be taxed. According
to the companion article “5 Tax Myths That Can Cost You Money” (Jeff
Schnepper, November 2009, at http://articles.moneycentral.msn.com/
Taxes/AvoidAnAudit/5taxMythsThatCanCostYouMoney.aspx), is it true
that students often are exempt from income taxes?

6.2 The U.S. Federal Income Tax Process
LEARNING OBJECTIVES
1. Identify the taxes most relevant for personal financial planning.

2. Identify taxable incomes and the schedules used to report them.
3. Calculate deductions, exemptions, and credits.
4. Compare methods of tax payment.
The U.S. government relies most on an income tax. The income tax is the most
relevant for personal financial planning, as everyone has some sort of income over
a lifetime. Most states model their tax systems on the federal model or base their
tax rates on federally defined income. While the estate tax may become more of a
concern as you age, the federal income tax system will affect you and your financial
decisions throughout your life.
Figure 6.4 "U.S. Individual Tax Form 1040, Page 1" shows an individual tax return,
U.S. Form 1040.
179
Figure 6.4 U.S. Individual Tax Form 1040, Page 1
6.2 The U.S. Federal Income Tax Process 180

Figure 6.5 U.S. Individual Tax Form 1040, Page 2
Taxable Entities
There are four taxable entities in the federal system: the individual or family unit,
the corporation, the nonprofit corporation, and the trust. Personal financial
planning focuses on your decisions as an individual or family unit, but other tax
entities can affect individual income. Corporate profit may be distributed to
individuals as a dividend8, for example, which then becomes the individual’s
taxable income. Likewise, funds established for a specific purpose may distribute
money to an individual that is taxable as individual income. A trust9, for example, is
a legal arrangement whereby control over property is transferred to a person or
organization (the trustee) for the benefit of someone else (the beneficiary). If you
were a beneficiary and received a distribution, that money would be taxable as
individual income.
8. A share of corporate profit
distributed to shareholders,
The definition of the taxable “individual” is determined by filing status:
usually as cash or corporate
stock.
9. A legal entity created to own • Single, never married, widowed, or divorced

and manage assets for the
benefit of beneficiaries.

• Married, in which case two adults file as one taxable “individual,”

combining all taxable activities and incomes, deductions, exemptions,
and credits
• Married filing separately, in which case two married adults file as two
separate taxable individuals, individually declaring and defining
incomes, deductions, exemptions, and credits
• Head-of-household, for a family of one adult with dependents
Some taxes are levied differently depending on filing status, following the
assumption that family structure affects ability to pay taxes.
All taxable entities have to file a declaration of incomes

and pay any tax obligations annually. Not everyone who Figure 6.6
files a return actually pays taxes, however. Individuals
with low incomes and tax exempt, nonprofit
corporations typically do not. All potential taxpayers
nevertheless must declare income and show their
obligations to the government. For the individual, that
declaration is filed on Form 1040 (or, if your tax
calculations are simple enough, Form 1040EZ).
Income Corporation
For individuals, the first step in the process is to

calculate total income. Income may come from many
sources, and each income must be calculated and declared. Some kinds of income
have a separate form or schedule to show their more detailed calculations. The
following schedules are the most common for reporting incomes separately by
source.
Schedule B: Interest and Dividend Income
Interest income is income from selling liquidity. For example, the interest that your
savings account, certificates of deposit, and bonds earn in a year is income. You
essentially are earning interest from lending cash to a bank, a money market
mutual fund, a government, or a corporation (though not all your interest income
may be taxable). Dividend income, on the other hand, is income from investing in
the stock market. Dividends are your share of corporate profits as a shareholder,
distributed in proportion to the number of shares of corporate stock you own.

Schedule C: Business Income
Business income is income from self-employment or entrepreneurial ventures or

business enterprises. For sole proprietors and partners in a partnership, business
income is the primary source of income. Many other individuals rely on wages, but
have a small business on the side for extra income. Business expenses can be
deducted from business income, including, for example, business use of your car
and home. If expenses are greater than income, the business is operating at a loss.
Business losses can be deducted from total income, just as business income adds to
total income.
The tax laws distinguish between a business and a hobby that earns or loses money.
You are considered to have a business for tax purposes if you made a profit in three
of the past five years including the current year, or if you are operating as a
registered business with the intention of making a profit. If you are operating your
own business you also must also pay self-employment tax on business income. In
addition, the self-employed must pay estimated income taxes in quarterly
installments based on expected income.
Tariq is thinking about turning his hobby into a

business. He has been successful buying and selling Figure 6.7
South Asian folk art online. He thinks he has found a
large enough market to support a business enterprise.
As a business he would be able to deduct the costs of
Web site promotion, his annual art buying trip, his
home office, and shipping, which would reduce the
taxes he would have to pay on his business income.
Tariq decides to enroll in online courses on becoming an
entrepreneur, how to write a business plan, and how to
find capital for a new venture.
Schedule SE: Self-Employment Tax © 2010 Jupiterimages

Corporation
Self-employment tax is an additional tax on income

from self-employment or business income earned by a
sole proprietor. It represents the employer’s
contribution to Social Security, which is a mandatory retirement savings program
of the federal government. Both employers and employees are required to
contribute to the employee’s Social Security account. When you are both the
employee and the employer, as in self-employment, you must contribute both
shares of the contribution.

Schedule D: Capital Gains (or Losses)
Gains or losses from investments derive from changes in asset value during
ownership between the asset’s original cost and its market value at the time of sale.
If you sell an asset for more than you paid for it, you have a gain. If you sell an asset
for less than you paid for it, you have a loss. Recurring gains or losses from
investment are from returns on financial instruments such as stocks and bonds.
One-time gains or losses, such as the sale of a home, are also reported on Schedule
D.
The tax code distinguishes between assets held for a short time—less than one year,
and assets held for a long time—one year or more. Short-term capital gains or losses
are taxed at a different rate than long-term capital gains or losses (Figure 6.8
"Capital Gains Tax Rates"). When you invest in financial assets, such as stocks,
bonds, mutual funds, property, or equipment, be sure to keep good records by
noting the date when you bought them and the original price. These records
establish the cost basis10 of your investments, which is used to calculate your gain
or loss when you sell them.
Figure 6.8 Capital Gains Tax Rates
Schedule E: Rental and Royalty Income; Income from Partnerships, S

Corporations, and Trusts
Rental or royalty income is income earned from renting an asset, either real
property or a creative work such as a book or a song. This can be a primary source
of income, although many individuals rely on wages and have some rental or
royalty income on the side. Home ownership may be made more affordable, for
example, if the second half of a duplex can be rented for extra income. Rental
10. The original cost of an asset
that is used to calculate a gain expenses can also be deducted from rental income, which can create a loss from
(loss) upon sale of the asset. rental activity rather than a gain. Unlike a business, which must become profitable

to remain a business for tax purposes, rental activities may generate losses year
after year. Such losses are a tax advantage, as they reduce total income.
Partnerships and S corporations are alternative business structures for a business

with more than one owner. For example, partnerships and S corporations are
commonly used by professional practices, such as accounting firms, law firms,
medical practices, and the like, as well as by family businesses.
The partnership or S corporation is not a taxable entity, but the share of its profits
distributed to each owner is taxable income for the owner and must be declared on
Schedule E.
Schedule F: Farm Income
Farm income is income from growing food, livestock, or livestock products, such as
wool, to sell. Farmers have a special status in the tax code, stemming from the
original agricultural basis of the U.S. economy and the strategic importance of self-
sufficiency in food production. Thus, the tax code applies exemptions specifically to
farmers.
Other Taxable and Nontaxable Income
Other taxable income includes alimony, state or local tax refunds, retirement fund
distributions from individual retirement accounts (IRAs) and/or pensions,
unemployment compensation, and a portion of Social Security benefits.
Your total income is then adjusted for items that the government feels should not
be taxed under certain circumstances, such as certain expenses of educators,
performing artists, and military reservists; savings in health savings or retirement
accounts; moving expenses; a portion of self-employment taxes; student loan
interest; tuition and educational fees; and alimony paid. Income that is not taxed by
the U.S. government and does not have to be reported as income includes the
following:
• Welfare benefits
• Interest from most municipal bonds
• Most gifts
• Most inheritance and bequests
• Workers compensation
• Veteran’s benefits
• Federal tax refunds

• Some scholarships and fellowships
It’s important to read tax filing instructions carefully, however, because not
everything you’d think would qualify actually does. The government allows
adjustments to be reported (or not reported) as income only under certain
circumstances or up to certain income limits, and some adjustments require special
forms.
The result of deducting adjustments from your total

income is a calculation of your adjusted gross income Figure 6.9
(AGI). Your AGI is further adjusted by amounts that may
be deducted or exempted from your taxable income and
by amounts already credited to your tax obligations.
Deductions, Exemptions, and Credits
Deductions and exemptions reduce taxable income,

while credits reduce taxes. Deductions are tax breaks © 2010 Jupiterimages
for incurring certain expenditures or living in certain Corporation
circumstances that the government thinks you should
not have to include in your taxable income. There are
deductions for age and for blindness. For other
deductions, there is a standard, lump-sum deduction
that you can take, or you may choose to itemize your deductions, that is, detail each
one separately and then calculate the total. If your itemized deductions are more
than your standard deduction, it makes sense to itemize.
Other deductions involve financial choices that the government encourages by

rewarding an extra incentive in the form of a tax break. Home mortgage interest is
a deduction to encourage home ownership, for example; investment interest is a
deduction to encourage investment, and charitable donations are deductions to
encourage charitable giving.
Deductions are also created for expenditures that may be considered

nondiscretionary, such as medical and dental expenses, job-related expenses, or
state and local income and property taxes. As with income adjustments, you have to
read the instructions carefully, however, to know what expenditures qualify as
deductions. Some deductions only qualify if they amount to more than a certain
percentage of income, while others may be deducted regardless. Some deductions
require an additional form to calculate specifics, such as unreimbursed employee or
job-related expenses, charitable gifts not given in cash, investment interest, and
some mortgage interest.

There are exemptions based on the number of your

dependents, who are usually children, but may be Figure 6.10
elderly parents or disabled siblings, that is, relatives
who generally cannot care for themselves financially.
Exemptions are made for dependents as
nondiscretionary expenditures, but the government
also encourages individuals to care for their financially
dependent children, parents, and siblings because
without such care they might become dependents of a
government safety net or a charity. © 2010 Jupiterimages
Corporation
After deductions and exemptions are subtracted from

adjusted gross income, the remainder is your taxable
income. Your tax is based on your taxable income, on a
progressive scale. You may have additional taxes, such as self-employment tax, and
you may be able to apply credits against your taxes, such as the earned income
credit for lower-income taxpayers with children.
Deductions, exemptions, and credits are some of the more disputed areas of the tax
code. Because of the depth of dispute about them, they tend to change more
frequently than other areas of the tax code. For example, in 2009, a credit was
added to encourage first-time homebuyers to purchase a home in the hopes of
stimulating the residential real estate market. As a taxpayer, you want to stay alert
to changes that may be to your advantage or disadvantage. Usually, such changes
are phased in and out gradually so you can include them in your financial planning
process.
Payments and Refunds
Once you have calculated your tax obligation for the year, you can compare that to
any taxes you have paid during the year and calculate the amount still owed or the
amount to be refunded to you.
You pay taxes during the tax year by having them withheld from your paycheck if
you earn income through wages, or by making quarterly estimated tax payments if
you have other kinds of income. When you begin employment, you fill out a form
(Form W-4) that determines the taxes to be withheld from your regular pay. You
may adjust this amount, within limits, at any time. If you have both wages and
other incomes, but your wage income is your primary source of income, you may be
able to increase the taxes withheld from your wages to cover the taxes on your
other income, and thus avoid having to make estimated payments. However, if your

nonwage income is substantial, you will have to make estimated payments to avoid
a penalty and/or interest.
The government requires that taxes are withheld or paid quarterly during the tax
year because it uses tax revenues to finance its expenditures, so it needs a steady
and predictable cash flow. Steady payments also greatly decrease the risk of taxes
being uncollectible. State and local income taxes must also be paid during the tax
year and are similarly withheld from wages or paid quarterly.
Besides income taxes, other taxes are withheld from your wages: payments for
Social Security and Medicare. Social Security or the Federal Insurance
Contributions Act (FICA) and Medicare are federal government programs. Social
Security is insurance against loss of income due to retirement, disability, or loss of a
spouse or parent. Individuals are eligible for benefits based on their own
contributions—or their spouse’s or parents’—during their working lives, so
technically, the Social Security payment withheld from your current wages is not a
tax but a contribution to your own deferred income. Medicare finances health care
for the elderly. Both programs were designed to provide minimal benefits to those
no longer able to sell their labor in exchange for wage income. In fact, both Social
Security and Medicare function as “pay-as-you-go” systems, so your contributions
pay for benefits that current beneficiaries receive.
If you have paid more during the tax year than your
actual obligation, then you are due a refund of the Figure 6.11
difference. You may have that amount directly
deposited to a bank account, or the government will
send you a check.
If you have paid less during the tax year than your
actual obligation, then you will have to pay the
difference (by check or credit card) and you may have to
pay a penalty and/or interest, depending on the size of © 2010 Jupiterimages
Corporation
your payment.
The deadline for filing income tax returns and for

paying any necessary amounts is April 15, following the
end of the tax year on December 31. You may file to request an extension of that
deadline to August 15. Should you miss a deadline without filing for an extension,
you will owe penalties and interest, even if your actual tax obligation results in a
refund. It really pays to get your return in on time.

KEY TAKEAWAYS
• The most relevant tax for financial planning is the income tax, as it
affects the taxpayer over an entire lifetime.
• Different kinds of income must be defined and declared on specific
income schedules and are subject to tax.
• Deductions and exemptions reduce taxable income.
• Credits reduce tax obligations.
• Payments are made throughout the tax year through withholding from
wages or through quarterly payments.

EXERCISES
1. Read the IRS document defining tax liability at http://www.irs.gov/

publications/p17/ch01.html#en_US_publink100031858. Do you have to
file a tax return for the current year? Why or why not? (Identify all the
factors that apply.) Which tax form(s) should you use?
2. Download and study the following schedules or their equivalent

for the current year. In what circumstances would you have to
file each one? Tentatively fill out any schedules that apply to you
for the current year.
◦ Schedules A: http://www.irs.gov/pub/irs-pdf/f1040sa.pdf
◦ Schedules B: http://www.irs.gov/pub/irs-pdf/f1040sb.pdf
◦ Schedule C: http://www.irs.gov/pub/irs-pdf/f1040sc.pdf
◦ Schedule D: http://www.irs.gov/pub/irs-pdf/f1040sd.pdf
◦ Schedule E: http://www.irs.gov/pub/irs-pdf/f1040se.pdf
◦ Schedule F: http://www.irs.gov/pub/irs-pdf/f1040sf.pdf
3. Find answers to the following questions at

http://www.finaid.org/scholarships/taxability.phtml.
a. Is financial aid for college subject to federal income tax?

b. Can federal and state education grants be taxed as income?
c. Are student loans taxable?
d. When is a scholarship tax exempt?
e. Do you have to be in a degree program to qualify for tax
exemption?
f. When can the cost of textbooks be deducted from gross
income for tax reporting purposes?
g. Can the amount of a scholarship used for tuition be
deducted?
h. Can living expenses while on scholarship be deducted?
i. Is the income and stipend from a teaching fellowship or
research assistantship tax exempt?
j. Are the tuition, books, and stipends of ROTC students tax
exempt?

6.3 Record Keeping, Preparation, and Filing
LEARNING OBJECTIVES
1. Identify sources of tax information.

2. Explain the importance of verifiable records and record keeping.
3. Compare sources of tax preparation assistance.
4. Trace the tax review process and its implications.
The Internal Revenue Code (IRC), the federal tax law, is written by the U.S. Congress
and enforced by the Internal Revenue Service (IRS), which is a part of the U.S.
Department of Treasury. The IRS is responsible for the collection of tax revenues.
To collect revenues, the IRS must inform the public of tax obligations and devise
data collection systems that will allow for collection and verification of tax
information so that collectible revenues can be verified. In other words, the IRS has
to figure out how to inform the public and collect taxes while also collecting enough
information to be able to check that those taxes are correct.
To inform the public, the IRS has published over six hundred separate publications
covering various aspects of the tax code. There are more than a thousand forms and
accompanying instructions to file complete tax information, although most
taxpayers actually file about half a dozen forms each year. In addition, the IRS
provides a Web site (http://www.irs.gov) and telephone support to answer
questions and assist in preparing tax filings.
By far, most income taxes from wages are collected through withholding as earned.
For most taxpayers, wages represent the primary form of income, and thus most of
their tax payments are withheld or paid as wages are earned. Still, everyone has to
file to summarize the details of the year’s incomes for the IRS and to calculate the
final tax obligation. In 2007, the IRS collected 138,893,908 individual returns
representing $1.367 trillion of tax revenue.Statistics of Income Division and Other
Areas of the Internal Revenue Service, http://www.irs.gov/taxstats (accessed
January 19, 2009).
Keeping Records
The individual filer must collect and report the information on tax forms and
schedules. Fortunately, this is not as difficult as the volume of data would suggest.
Employers are required to send Form W-2 to each employee at the end of the year,
191
detailing the total wages earned and taxes and contributions withheld. If you have
earned other kinds of income, your clients, customers, retirement fund, or other
source of income may have to file a Form 1099 to report that income to you and to
the IRS. Interest and dividend income is also reported by the bank or brokerage
firm on Form 1099. The W-2 and the Form 1099 are reported to both the IRS and
you.
The system for filing tax information has purposeful redundancies. Where possible,
information is collected independently from at least two sources, so it can be
verified. For example, your wage data is collected both from you and from your
employer, your interest and dividend incomes are reported by both you and the
bank or brokerage that paid them, and so on. Those redundancies, wherever
practical, allow for a system of cross-references so that the IRS can check the
validity of the data it receives.
Incomes may be summarized and reported to you, but

only you know your expenses. Expenditures are Figure 6.12
important if they are allowed as deductions, such as
charitable gifts, medical and dental expenses, job-
related expenses, and so on, so data should be collected
throughout the tax year. If you do nothing more than
keep a checkbook, then you will have to go through it
and identify the deductible expenses for the tax year.
Financial software applications will make that task
easier; most allow you to flag deductible expenses in © 2010 Jupiterimages
your initial setup. Corporation
You should also keep receipts of purchases that may be

deductible; credit or debit card statements and bank
statements provide convenient backup proof of expenditures. Proof is needed in the
event the IRS questions the accuracy of your return.
Tax Preparation and Filing
After you have collected the information you need, you fill out the forms. The tax
code is based on the idea that citizens should create revenues for the government
based on their ability to pay—and the tax forms follow that logic. Most taxpayers
need to complete only a few schedules and forms to supplement their Form 1040 (or
1040 EZ). Most taxpayers have the same kinds of taxable events, incomes, and
deductions year after year and file the same kinds of schedules and forms.
6.3 Record Keeping, Preparation, and Filing 192

Many taxpayers prefer to consult a professional tax preparer. Professional help is

useful if you have a relatively complicated tax situation: unusual sources of income
or expenditures that may be deductible under unusual circumstances. Some
taxpayers use a tax preparer simply to protect against making a mistake and having
the error, however, innocent, prove costly to fix. Fees for tax preparers depend on
how complex your return is, the number of forms that need to be completed, and
the type of professional you consult.
Professional tax preparers may be lawyers, accountants, personal financial

planners, or tax consultants. You may have an ongoing relationship with your tax
preparer who may also be your accountant or financial planner, working with you
on other financial decisions. Or you may consult a tax preparer simply on tax issues.
You may want your tax preparer to fill out and file the forms for you, or you may be
looking for advice about future financial decisions that have tax consequences. Tax
preparers may be independent practitioners who work during tax season, or
employees of a national chain that provide year-round tax services.
There is no standard certification to be a professional tax preparer. An enrolled

agent is someone who has successfully passed training courses from the IRS. A
certified public accountant (CPA) has specific training and experience in
accounting. When looking for a tax preparer, your lawyer, accountant, or financial
planner may be appropriate or may be able to make a recommendation. If your
information is fairly straightforward, you may minimize costs by using a preparer
who simply does taxes. If your situation involves more complications, especially
involving other entities such as businesses or trusts, or unusual circumstances such
as a gain, gift, or distribution, you may want to consult a professional with a range
of expertise, such as an accountant or a lawyer who specializes in taxes. Many
professionals also offer a “guarantee,” that is, that they will also help you if the
information on your return is later questioned by the IRS.
Whether you prepare your tax return by yourself or

with a professional, it is you who must sign the return Figure 6.13
and assume responsibility for its details. You should be
sure to review your return with your tax preparer so
that you understand and can explain any of the
information found on it. You should question anything
that you cannot understand or that seems contrary to
your original information. You should also know your
tax return because understanding how and why tax
obligations are created or avoided can help you plan for
tax consequences in future financial decisions.

You may choose to prepare the return yourself using a

tax preparation software application. There are many © 2010 Jupiterimages
available, and several that are compatible with personal Corporation
financial software applications, enabling you to
download or transfer data from your financial software
directly into the tax software. Software applications are
usually designed as a series of questions that guide you through Form 1040 and the
supplemental schedules, filling in the data from your answers. Once you have been
through the “questionnaire,” it tells you the forms it has completed for you, and
you can simply print them out to submit by mail or “e-file” them directly to the IRS.
Most programs also allow you to enter data into the individual forms directly.
Many tax preparation software packages are available, and many are reviewed in
the business press or online. Some popular programs include the following (see
http://tax-software- review.toptenreviews.com):
• Turbo Tax
• Tax Cut
• Tax
• ACT
• Complete Tax
• TaxSlayer Premium
• TaxBrain 1040 Deluxe
• OLT Online Taxes
Software can be useful in that it automatically calculates unusual circumstances,

limitations, or exceptions to rules using your complete data. Some programs even
prompt you for additional information based on the data you submit. Overlooking
exceptions is a common error that software programs can help you avoid. The
programs have all the forms and schedules, but if you choose to file hard copy
versions, you can download them directly from the IRS Web site, or you can call the
IRS and request that they be sent to you. Once your return is completed, you must
file it with the IRS, either by mail or by e-file, which has become increasingly
popular.
Following Up
After you file your tax return it will be processed and reviewed by the IRS. If you are
owed a refund, it will be sent; if you paid a payment, it will be deposited. The IRS
reviews returns for accuracy, based on redundant reporting and its “sense” of your
data. For example, the IRS may investigate any discrepancies between the wages
you report and the wages your employer reports. As another example, if your total

wages are $23,000 and you show a charitable contribution of $20,000, that
contribution seems too high for your income—although there may be an
explanation.
The IRS may follow up by mail or by a personal interview. It may just ask for
verification of one or two items, or it may conduct a full audit11—a thorough
financial investigation of your return. In any case, you will be asked to produce
records or receipts that will verify your reported data. Therefore, it is important to
save a copy of your return and the records and receipts that you used to prepare it.
The IRS has the following recommendations for the number of years to save your
tax data:
1. If you owe additional tax and situations 2, 3, and 4 below do not apply
to you, keep records for three years.
2. If you do not report income that you should report, and it is more than
25 percent of the gross income shown on your return, keep records for
six years.
3. If you file a fraudulent return, keep records indefinitely.
4. If you do not file a return, keep records indefinitely.
5. If you file a claim for credit or refund after you file your return, keep
records for three years from the date you filed your original return or
two years from the date you paid the tax, whichever is later.
6. If you file a claim for a loss from worthless securities or bad debt
deduction, keep records for seven years.
7. Keep all employment tax records for at least four years after the date
that the tax becomes due or is paid, whichever is later.
If you have a personal interview, your tax preparer may accompany you to help
explain and verify your return. Ultimately, however, you are responsible for it. If
you have made errors, and if those errors result in a larger tax obligation (if you
owe more), you may have to pay penalties and interest in addition to the tax you
owe. You may be able to negotiate a payment schedule with the IRS.
The IRS randomly chooses a certain number of returns each year for review and
possible audit even where no discrepancies or unusual items are noticed. The threat
of a random audit may deter taxpayers from cheating or taking shortcuts on their
tax returns. Computerized record keeping has made it easier for both taxpayers and
the IRS to collect, report, and verify tax data.
11. A review of tax calculations

and obligations performed by
the Internal Revenue Service
(IRS).

Filing Strategies
Most citizens recognize the need to contribute to the government’s revenues but
want to avoid paying more than they need to. Tax avoidance12 is the practice of
ensuring that you have no excess tax obligations. Strategies for minimizing or
avoiding tax obligations are perfectly legal. However, tax evasion13—fraudulently
reporting tax obligations, for example, by understating incomes and gains or
overstating expenses and losses—is illegal.
Timing can affect the value of taxable incomes or deductibles expenses. If you
anticipate a significant increase in income—and therefore in your tax rate—in the
next tax year, you may try to defer a deductible expense. When you have more
income and it is taxed at a higher rate, a deductible expense may be worth more as
a tax savings to offset your income. For example, if your tax rate is 20 percent and
your deductible expense of $100 saves you from paying taxes on $100, then it saves
you $20 in taxes. If your tax rate is 35 percent, that same $100 deductible saves you
$35. Likewise, if you anticipate a decrease in income that will decrease your tax
rate, you may want to defer receipt of income until the next year when it will be
taxed at a lower rate. In addition, some kinds of incomes are taxed at different rates
than others, so how your income is created may bear on how much tax it creates.
The definition of expenses and the way you claim them

can affect the tax they save. You may be able to deduct Figure 6.14
more expenses if you itemize your deductions than if
you do not, or it may not make a difference. Also, there
is some discretion in classifying expenses. For example,
suppose you are a high school Spanish teacher. You also
tutor students privately. You buy Spanish books to
improve your own language skills and to keep current
with the published literature. Are the costs of those
books an unreimbursed employee expense related to © 2010 Jupiterimages
your job as a teacher, or are they an expense of your Corporation
private tutoring business?
They may be both, but you can only claim the expense
once or in one place on your tax return. If you claim it as an employment-related
expense, your ability to deduct the cost may be limited, but if it is a cost of your
12. The legal attempt to minimize tutoring business, you may be able to fully expense it from your business income.
tax obligations.
13. The illegal attempt to report An income that is not taxed or taxed at a lower rate is more valuable than an
financial information income that is taxed or taxed at a higher rate. An expense that is fully deductible is
fraudulently to minimize tax
more valuable than an expense that is not. Taxes deferred—by delaying income or
obligations.

accelerating expense—create more liquidity and thus more value. However, taxable
income is still income, and a deductible expense is still an expense. Tax
consequences should not obscure the benefits of enjoying income and the costs of
incurring expenses.
There are many ideas about how to avoid an audit or what will trigger one: certain
kinds of incomes or expenses, or filing earlier or later, for example. In truth, with
the increased sophistication of computerization, the review process is much better
at noticing real discrepancies and at choosing audits randomly. Time and effort
(and cost) invested in outsmarting a possible audit is usually wasted. The best
protection against a possible audit is to have verification—a receipt or a bill or a
canceled check—for all the incomes and expenses that you report.
KEY TAKEAWAYS
• Tax code information is available from the Internal Revenue Service.

• Verifiable records must be kept for all taxable incomes and expenses or
other taxable events and activities.
• Professional tax assistance and tax preparation software are readily
available.
• The Internal Revenue Service reviews tax returns for errors and may
follow up through an informal or formal audit process.
• Tax avoidance is the legal practice of minimizing tax obligations.
• Tax evasion is the illegal process of fraudulently presenting information
used in calculating tax obligations.
• Tax avoidance strategies can involve the timing of incomes and/or
expenses to take advantage of changing tax circumstances.

EXERCISES
1. Read the article “Policy Basics: Where Do Our Federal Tax Dollars Go”
(Center on Budget and Policy Priorities, April 13, 2009) at
http://www.cbpp.org/cms/index.cfm?fa=view&id=1258. In 2008, what
were the federal government’s three largest expenditures of tax dollars?
According to the IRS.gov article “Tips for Choosing a Tax Preparer” at
http://www.irs.gov/newsroom/article/0,,id=251962,00.html, when
should you look for in a professional tax preparation service provider,
and what fees should you avoid paying?
2. Gather a current sample of the kind of records you will use to calculate
your tax liability this year and to verify your tax return. List each type of
record and identify exactly what information it will give you, your tax
preparer, and the IRS about your tax situation. What additional records
will you need that are not yet in your possession?
3. Compare and contrast tax preparation software at sites such as
http://financialplan.about.com/od/software/tp/TPTaxSoftware.htm
and http://www.consumersearch.com/tax-preparation-software/
reviews. What are the chief differences among the top three or four
programs? Also check out the IRS Free File program at
http://www.irs.gov/efile. Would you quality for Free File?
4. Use your spreadsheet program, or download a free one, to develop a
document showing monthly cash flows for income and expenses to date
for which you have written records. If you continue to develop this
document for the remaining months, how will it help you prepare your
tax returns?
5. Research how can you reduce your tax liability and/or avoid paying
taxes when you file this year. Work with classmates to develop a tip
sheet for students on tax avoidance.

6.4 Taxes and Financial Planning
LEARNING OBJECTIVES
1. Trace the tax effects of life stages and life changes.

2. Identify goals and strategies that provide tax advantages.
3. Identify tax advantages that may be useful in pursuing your goals.
4. Discuss the relationship of tax considerations to financial planning.
You may anticipate significant changes in income or expenses based on a change of

job or career, or a change of life stage or lifestyle. Not only may the amounts of
income or expenses change, but the kinds of incomes or expenses may change as
well. Planning for those changes in relation to tax obligations is part of personal
financial planning.
Tax Strategies and Life Stages
Tax obligations change more broadly as your stage of life changes. Although
everyone is different, there is a typical pattern to aging, earning, and taxes, as
shown in Figure 6.15 "Life Stages and Tax Implications".
Figure 6.15 Life Stages and Tax Implications
In young adulthood, you rely on income from wages, and you usually have yet to
acquire an asset base, so you have little income from interest, dividends, or capital
gains. Your family structure does not include dependents, so you have few
deductions but also low taxable income.
199
As you progress in your career, you can expect wages, expenses, and dependents to
increase. You are building an asset base by buying a home, possibly saving for your
children’s education, or saving for retirement. Because those are the kinds of assets
encouraged by the government, they not only build wealth but also create tax
advantages—the mortgage interest deduction, retirement, or education savings
exemption.
In older adulthood, you may begin to build an asset base

that can no longer provide those tax advantages that Figure 6.16
are limited or may create taxable income such as
interest, dividends, or rental income. In retirement,
most people can anticipate a significant decrease in
income from wages and a significant increase in
reliance on incomes from investments such as interest,
dividends, and gains. Some of those assets may be
retirement savings accounts, such as an Individual
Retirement Account (IRA) or 401(k) that created tax
advantages while growing, but will create tax
obligations as income is drawn from them.
Generally, you can expect your income to increase

during your middle adult life, but that is when many
people typically have dependents and deductions such © 2010 Jupiterimages
as mortgage interest and job-related expenses to offset Corporation
increased tax obligations. As you age, and especially
when you retire, you can expect less income and also
fewer deductions: any kids have left home, the
mortgage in paid off.
The bigger picture is that at the stages of your life when income is increasing, so are
your deductions and exemptions, which tend to decrease as your income decreases.
Although your incomes change over your lifetime, you tax obligations change
proportionally, so they remain relative to your ability to pay.
The tax consequences of such changes should be anticipated and considered as you
evaluate choices for financial strategies. Because the tax code is a matter of law it
does change, but because it is also a matter of politics, it changes slowly and only
after much public discussion. You can usually be aware of any tax code changes far
enough in advance to incorporate them into your planning.
6.4 Taxes and Financial Planning 200

Tax Strategies and Personal Financial Planning
Tax advantages are sometimes created for personal financial strategies as a way of
encouraging certain personal goals. In the United States, as in most developed
economies, certain goals such as home ownership, retirement savings, and
education and health financing are seen as personal goals that benefit society as
well as the individual.
In most cases, tax advantages are created to encourage progress toward those goals.
For example, most people can buy a home only if they can use debt financing, which
creates added costs. So mortgage interest, that added cost, is tax deductible (up to a
limit) to make home financing and therefore home ownership more affordable and
attractive.
Retirement saving is encouraged, so some savings plans such as an IRA or a defined

contribution14 plan such as a 401(k) or a 403b (so named for the sections of the
Internal Revenue Code that define them) create tax advantages. The deposits made
to those plans may be used to reduce taxable income, although there are limits to
the amount of those deposits. There are also retirement savings strategies that do
not create tax advantages, such as saving outside of a tax-advantaged account.
There are limited tax-advantaged savings accounts for education savings and health
care expenses as well.
Where you have a choice, it makes sense to use a

strategy that will allow you to make progress toward Figure 6.17
your goal and realize a tax advantage. Your enthusiasm
for the tax advantage should not define your goals,
however. Taxes affect the value of your alternatives, so
recognizing tax implications should inform your choices
without defining your goals.
Unanticipated events such as an inheritance, a gift,

lottery winnings, casualty and theft losses, or medical © 2010 Jupiterimages
Corporation
expenses can also have tax consequences. They are
often unusual events (and therefore unanticipated) and
may be unfamiliar and financially complicated. In those
circumstances it may be wise to consult an expert.
14. A tax-advantaged pension plan,
such as a 401(k), that both Your financial plans should reflect your vision for your life: what you want to have,
employer and employee may
contribute to and that does not
how you want to get it, how you want to protect it. You will want to be aware of tax
pay an obligated or defined advantages or disadvantages, but tax consequences should not drive your vision.
benefit at maturity. You would not buy a house with a mortgage only to get the mortgage interest

deduction, for example. However, if you are buying a home, you can plan to do so in
the most tax-advantageous way.
As Supreme Court Justice Oliver Wendell Holmes, Jr., said, “Taxes are what we pay
for a civilized society.”U.S. Department of the Treasury, http://www.treas.gov/
education/faq/taxes/taxes-society.shtml (accessed January 19, 2009). Like any
costs, you want to minimize your tax costs of living and of life events, but tax
avoidance is only a means to an end. You should make your life choices for better
reasons than avoiding taxes.
KEY TAKEAWAYS
• Tax strategies may change as life stages and family structure changes.
• Some personal finance goals may be pursued in a more or less tax-
advantaged way, so you should evaluate the tax effects on your
alternatives.
• Tax strategies are a means to an end, that is, to achieve your personal
finance goals with a minimum of cost.

EXERCISES
1. Review your list of personal financial goals. For each goal, how does the
U.S. Tax Code help or hinder you in achieving it?
2. Investigate tax strategies that would benefit you in your present life
stage. Begin your online research at this comprehensive list of tax links:
http://www.el.com/elinks/taxes/. What tax strategies would benefit
you in your next life stage? Share your findings and strategies with
others in your life stage.
3. What does Benjamin Franklin mean in the following quote about
taxation? What advice is implied and how would you apply that advice
to your financial planning?
“Friends and neighbors complain that taxes are indeed very heavy, and if
those laid on by the government were the only ones we had to pay, we might
the more easily discharge them; but we have many others, and much more
grievous to some of us. We are taxed twice as much by our idleness, three
times as much by our pride, and four times as much by our folly.”
- Benjamin FranklinBenjamin Franklin, “As Certain as Death—Quotations

About Taxes,” compiled and arranged by Jeffrey Yablon, in Tax Notes, January
5, 2004; retrieved from http://www.taxanalysts.com/www/features.nsf/
Articles/B613CDAB6D2554218525770000641571?OpenDocument (accessed May
23, 2012).

Chapter 7
Financial Management
Introduction
Financial management is about managing the financing for consumption and

investment. You have two sources for money: yourself or someone else. You need to
decide when to use whose money and how to do so as efficiently as possible:
maximizing benefit and minimizing cost. As with all financial decisions, you also
need to think about the strategic consequences for future decisions.
You can use your own money as a source of financing if your income is at least
equal to your living expenses. If it is more, you have a budget surplus that can be
saved and used as a source of future financing while earning income at the same
time. If your own income is less than the expenses, you have a budget deficit that
will require another external source of financing—someone else’s money—that will
add an expense. Ideally, you want to avoid the additional expense of borrowing and
instead create the additional income from saving. The budgeting techniques
discussed in Chapter 5 "Financial Plans: Budgets" are helpful in seeing this picture
more clearly.
Your ability to save will vary over your lifetime, as your

family structure, age, career choice, and health will Figure 7.1
change. Those “micro” factors determine your income
and expenses and thus your ability to create a budget
surplus and your own internal financing. Likewise, your
need to use external financing, such as credit or debt,
will vary with your income, expenses, and ability to
save.
At times, unexpected change can turn a budget surplus

into a budget deficit (e.g., a sudden job loss or increased
health expenses), and a saver can reluctantly become a
borrower. Being able to recognize that change and
understand the choices for financing and managing
cash flow will help you create better strategies.
204
Chapter 7 Financial Management
Financing can be used to purchase a long-term asset

that will generate income, reduce expense, or create a © 2010 Jupiterimages
gain in value, and it may be useful when those benefits Corporation
outweigh the cost of the debt. The benefit of long-term
assets is also influenced by personal factors. For
example, a house may be more useful, efficient, and
valuable when families are larger.
Macroeconomic factors, such as the economic cycle, employment, and inflation,

should bear on your financing decisions as well. Your incomes and expenses are
affected by the economy’s expansion or contraction, especially as it affects your
own employment or earning potential. Inflation or deflation, or an expected
devaluation or appreciation of the currency, affects interest rates as both lenders
and borrowers anticipate using or returning money that has changed in value.
Financial management decisions become more complicated when the personal and
macroeconomic factors become part of the decision process, but the result is a more
realistic evaluation of alternatives and a better strategy that leaves more choices
open in the future. Financial management decisions, however, are difficult not
because of their complexity, but because the way you can finance your assets and
expenses (i.e., lifestyle) determines the life that you live. The stakes are high.
205
7.1 Your Own Money: Cash
LEARNING OBJECTIVES
1. Identify the cash flows and instruments used to manage income deposits
and expense payments.
2. Explain the purpose of check balancing.
Most people use a checking account1 as their primary means of managing cash
flows for daily living. Incomes from wages and perhaps from investments are
deposited to this account, and expenses are paid from it. The actual deposit of
paychecks and writing of checks, however, has been made somewhat obsolete as
more cash flow services are provided electronically.
When incoming funds are distributed regularly, such as a paycheck or a

government distribution, direct deposit2 is preferred. For employers and
government agencies, it offers a more efficient, timely, and secure method of
distributing funds. For the recipient, direct deposit is equally timely and secure and
1. A bank account that is used to
can allow for a more efficient dispersal of funds to different accounts. For example,
facilitate payment by check.
you may have some of your paycheck directly deposited to a savings account, while
2. An automatic deposit of the rest is directly deposited to your checking account to pay living expenses.
income directly to the
Because you never “see” the money that is saved, it never passes through the
receiver’s designated bank
account; widely used by account that you “use,” so you are less likely to spend it.
employers and government
agencies.
Withdrawals or payments have many electronic options. Automatic payments3
3. A direct payment of an expense may be scheduled to take care of a periodic payment (i.e., same payee, same
or a debt payment made as an
electronic transfer of funds amount) such as a mortgage or car payment. They may also be used for periodic
from the payer’s bank account expenses of different amounts—for example, utility or telephone expenses. A debit
to the payee’s. card4 may be used to directly transfer funds at the time of purchase; money is
4. A card that allows point-of-sale withdrawn from your account and transferred to the payee’s with one quick swipe
payment as an electronic at checkout. An ATM (automated teller machine) card5 offered by a bank allows
transfer of funds from the for convenient access to the cash in your bank accounts through instant cash
payer’s bank account to the
withdrawals.
payee’s at the time of sale.
5. A card allowing direct access to

a bank account through an The bank clears these transactions as it manages your account, providing
automated teller machine statements of your cash activities, usually monthly and online. When you reconcile
(ATM), most often used to your record keeping (i.e., your checkbook or software accounts) with the bank’s
access cash without having to
go to the bank housing the statement, you are balancing your checking account. This ensures that your records
account. and the bank’s records are accurate and that your information and account balance
206
and the bank’s are up to date. Banks do make mistakes, and so do you, so it is
important to check and be sure that the bank’s version of events agrees with yours.
KEY TAKEAWAYS
• A checking account is the primary cash flow management tool for most
consumers, providing a way to pay for expenses and store cash until it is
needed.
• Balancing your checkbook reconciles your personal records with the
bank’s records of your checking account activity.
EXERCISES
1. In My Notes or your personal finance journal, inventory in detail all the

vehicles you use for managing your cash flows. Include all your accounts
that are mediated through banks and finance companies. Also, list your
cards issued by banks, such as debit or ATM cards, and identify any
direct deposits and automatic payments that are made through your
savings and checking accounts. How might you further enhance your
cash management through the use of banking tools?
2. Does your bank offer online banking services, such as electronic bill
payment? View your bank and others (such as
http://www.ingdirect.com) online to learn more about Internet
banking. What products and services do online branches and banks
offer? Do you (or would you) use those products and services? Why (or
why not)? Discuss online banking with classmates. What do they identify
as the main benefits and risks of electronic banking?
7.1 Your Own Money: Cash 207

7.2 Your Own Money: Savings
LEARNING OBJECTIVES
1. Identify the markets and institutions used for saving.

2. Compare and contrast the instruments used for saving.
3. Analyze a savings strategy in terms of its liquidity and risk.
When incomes are larger than expenses, there is a budget surplus, and that surplus
can be saved. You could keep it in your possession and store it for future use, but
then you have the burden of protecting it from theft or damage. More important,
you create an opportunity cost. Because money trades in markets and liquidity has
value, your alternative is to lend that liquidity to someone who wants it more than
you do at the moment and is willing to pay for its use. Money sitting idle is an
opportunity cost.
The price that you can get for your money has to do with supply and demand for
liquidity in the market, which in turn has to do with a host of other macroeconomic
factors. It also has a lot to do with time, opportunity cost, and risk. If you are willing
to lend your liquidity for a long time, then the borrower has more possible uses for
it, and increased mobility increases its value. However, while the borrower has
more opportunity, you (the seller) have more opportunity cost because you give up
more choices over a longer period of time. That also creates more risk for you, since
more can happen over a longer period of time. The longer you lend your liquidity,
the more compensation you need for your increased opportunity cost and risk.
Savings Markets
The markets for liquidity are referred to as the money markets6 and the capital
markets7. The money markets are used for relatively short-term, low-risk trading
of money, whereas the capital markets are used for relatively long-term, higher-
risk trading of money. The different time horizons and risk tolerances of the
buyers, and especially the sellers, in each market create different ways of trading or
packaging liquidity.
6. A market where short-term When individuals are saving or investing for a long-term goal (e.g., education or
liquidity is traded. retirement) they are more likely to use the capital markets; their longer time
7. A market where long-term horizon allows for greater use of risk to earn return. Saving to finance consumption
liquidity is traded. relies more on trading liquidity in the money markets, because there is usually a
208
shorter horizon for the use of the money. Also, most individuals are less willing to
assume opportunity costs and risks when it comes to consumption, thus limiting
the time that they are willing to lend liquidity.
When you save, you are the seller or lender of liquidity. When you use someone
else’s money or when you borrow, you are the buyer of liquidity.
Savings Institutions
For most individuals, access to the money markets is done through a bank. A bank
functions as an intermediary8 or “middleman” between the individual lender of
money (the saver) and the individual borrower of money.
For the saver or lender, the bank can offer the convenience of finding and screening
the borrowers, and of managing the loan repayments. Most important, a bank can
guarantee the lender a return: the bank assumes the risk of lending. For the
borrowers, the bank can create a steady supply of surplus money for loans (from
the lenders), and arrange standard loan terms for the borrowers.
Banks create other advantages for both lenders and borrowers. Intermediation
allows for the amounts loaned or borrowed to be flexible and for the maturity of the
loans to vary. That is, you don’t have to lend exactly the amount someone wants to
borrow for exactly the time she or he wants to borrow it. The bank can
“disconnect” the lender and borrower, creating that flexibility. By having many
lenders and many borrowers, the bank diversifies the supply of and demand for
money, and thus lowers the overall risk in the money market.
The bank can also develop expertise in screening borrowers to minimize risk and in
managing and collecting the loan payments. In turn, that reduced risk allows the
bank to attract lenders and diversify supply. Through diversification and expertise,
banks ultimately lower the cost of lending and borrowing liquidity. Since they
create value in the market (by lowering costs), banks remain as intermediaries or
middlemen in the money markets.
There are different kinds of banks based on what kind of brokering of money the
bank does. Those differences have become less distinct as the banking industry
consolidates and strives to offer more universal services. In the last generation,
8. A third party that facilitates decreasing bank regulation, increasing globalization, and technology have all
trade between two parties. In contributed to that trend. Different kinds of banks are listed below.
financial services, a bank is an
intermediary between lenders
and borrowers. • Retail banks have focused on consumer saving and borrowing.
7.2 Your Own Money: Savings 209

• Commercial banks have focused on operating cash flow management

for businesses.
• Investment banks have focused on long-term financing for businesses.
Retail banks are commonly known as thrift institutions, savings banks, savings and
loan associations, or mutual savings banks and are usually private or public
corporations. Credit unions9 function similarly, but are cooperative membership
organizations, with depositors as members.
In addition to banks, other kinds of intermediaries for savers include pension funds,
life insurance companies, and investment funds. They focus on saving for a
particular long-term goal. To finance consumption, however, most individuals
primarily use banks.
Some intermediaries have moved away from the “bricks-and-mortar” branch model
and now operate as online banks, either entirely or in part. There are cost
advantages for the bank if it can use online technologies in processing saving and
lending. Those cost savings can be passed along to savers in the form of higher
returns on savings accounts or lower service fees. Most banks offer online and,
increasingly, mobile account access, via cell phone or smartphone. Intermediaries
operating as finance companies offer similar services.
Because their role as intermediaries is critical to the flow of funds, banks are
regulated by federal and state governments. Since the bank failures of the Great
Depression, bank deposits are federally insured (up to $250,000) through the FDIC
(Federal Deposit Insurance Corporation). Since the financial crisis of 2007–2009,
bank money market funds also are insured. Credit union accounts are similarly
insured by the National Credit Union Agency or NCUA, also an independent federal
agency. In choosing an intermediary, savers should make sure that accounts are
FDIC or NCUA insured.
Saving Instruments
Banks offer many different ways to save your money until you use it for
consumption. The primary difference among the accounts offered to you is the
price that your liquidity earns, or the compensation for your opportunity cost and
9. A retail banking institution
that is either depositor- or risk, which in turn depends on the degree of liquidity that you are willing to give
member-owned. Membership up. You give up more liquidity when you agree to commit to a minimum time or
is usually defined and limited amount of money to save or lend.
to affiliation with a particular
group—for example, state or
union employees, or a religious
or social affiliation.

For the saver, a demand deposit10 (e.g., checking

account) typically earns no or very low interest but Figure 7.2
allows complete liquidity on demand. Checking
accounts that do not earn interest are less useful for
savings and therefore more useful for cash
management. Some checking accounts do earn some
interest, but often require a minimum balance. Time
deposits11, or savings accounts, offer minimal interest
or a bit more interest with minimum deposit
requirements.
If you are willing to give up more liquidity, certificates

of deposit (CDs)12 offer a higher price for liquidity but
extract a time commitment enforced by a penalty for
early withdrawal. They are offered for different © 2010 Jupiterimages
maturities, which are typically from six months to five Corporation
years, and some have minimum deposits as well. Banks
also can offer investments in money market mutual
funds (MMMFs)13, which offer a higher price for
liquidity because your money is put to use in slightly higher-risk investments, such
as Treasury bills (short-term government debt) and commercial paper (short-term
corporate debt).
Compared to the capital markets, the money markets have very little risk, so
MMMFs are considered very low-risk investments. The trade-offs between liquidity
and return are seen in Figure 7.3 "Savings Products versus Liquidity and Risk".
10. Accounts from which

withdrawals may be made “on
demand,” such as a checking
account.
11. An account from which

withdrawals are made over
time, or funds that are
deposited for a time.
12. A savings instrument requiring

a minimum sacrifice of
liquidity, either as a minimum
deposit amount or a minimum
time deposited, in exchange for
a higher rate of earnings.
13. A savings instrument invested

in the money markets.

Figure 7.3 Savings Products versus Liquidity and Risk
As long as your money remains in your account, including any interest earned while
it is there, you earn interest on that money. If you do not withdraw the interest
from your account, it is added to your principal balance, and you earn interest on
both. This is referred to as earning interest on interest, or compounding. The rate
at which your principal compounds is the annual percentage rate (APR)14 that
your account earns.
You can calculate the eventual value of your account by using the relationships of
time and value that we looked at in Chapter 4 "Evaluating Choices: Time, Risk, and
Value"—that is,
FV = PV × (1 + r)t ,
where FV = future value, PV = present value, r = rate, and t = time. The balance in
your account today is your present value, PV; the APR is your rate of compounding,
r; the time until you will withdraw your funds is t. Your future value depends on the
rate at which you can earn a return or the rate of compounding for your present
account.
If you are depositing a certain amount each month or with each paycheck, that
stream of cash flows is an annuity. You can use the annuity relationships discussed
in Chapter 4 "Evaluating Choices: Time, Risk, and Value" to project how much the
14. The annual rate of interest on
account will be worth at any point in time, given the rate at which it compounds.
credit or debt.

Many financial calculators—both online and handheld—can help you make those
calculations.
Ideally, you would choose a bank’s savings instrument that offers the highest APR
and most frequent compounding. However, interest rates change, and banks with
savings plans that offer higher yields often require a minimum deposit, minimum
balance, and/or a maintenance fee. Also, your interest from savings is taxable, as it
is considered income. As you can imagine, however, with monthly automatic
deposits into a savings account with compounding interest, you can see your wealth
can grow safely.
Savings Strategies
Your choice of savings instrument should reflect your liquidity needs. In the money
markets, all such instruments are relatively low risk, so return will be determined
by opportunity cost.
You do not want to give up too much liquidity and then risk being caught short,
because then you will have to become a borrower to make up that shortfall, which
will create additional costs. If you cannot predict your liquidity needs or you know
they are immediate, you should choose products that will least restrict your
liquidity choices. If your liquidity needs are more predictable or longer term, you
can give up liquidity without creating unnecessary risk and can therefore take
advantage of products, such as CDs, that will pay a higher price.
Your expectations of interest rates will contribute to your decision to give up

liquidity. If you expect interest rates to rise, you will want to invest in shorter-term
maturities, so as to regain your liquidity in time to reinvest at higher rates. If you
expect interest rates to fall, you would want to invest in longer-term maturities so
as to maximize your earnings for as long as possible before having to reinvest at
lower rates.
One strategy to maximize liquidity is to diversify your savings in a series of

instruments with differing maturities. If you are using CDs, the strategy is called
“CD laddering.” For example, suppose you have $12,000 in savings earning 0.50
percent annually. You have no immediate liquidity needs but would like to keep
$1,000 easily available for emergencies. If a one-year CD is offering a 1.5 percent
return, the more savings you put into the CD, the more return you will earn, but the
less liquidity you will have.

A “laddering” strategy allows you to maximize return and liquidity by investing

$1,000 per month by buying a one-year CD. After twelve months, all your savings is
invested in twelve CDs, each earning 1.5 percent. But because one CD matures each
month, you have $1,000 worth of liquidity each month. You can keep the strategy
going by reinvesting each CD as it matures. Your choices are shown in Figure 7.4
"CD Laddering Strategy".
Figure 7.4 CD Laddering Strategy
A laddering strategy can also reflect expectations of interest rates. If you believe
that interest rates or the earnings on your money will increase, then you don’t want
to commit to the currently offered rates for too long. Your laddering strategy may
involve a series of relatively short-term (less than one year) instruments. On the
other hand, if you expect interest rates to fall, you would want to weight your
laddering strategy to longer-term CDs, keeping only your minimum liquidity
requirement in the shorter-term CDs.
The laddering strategy is an example of how diversifying maturities can maximize

both earnings and liquidity. In order to save at all, however, you have to choose to
save income that could otherwise be spent, suffering the opportunity cost of
everything that you could have had instead. Saving is delayed spending, often seen
as a process of self-denial.

One saving strategy is to create regular deposits into a

separate account such that you might have a checking Figure 7.5
account from which you pay living expenses and a
savings account in which you save.
This is easier with direct deposit of wages, since you can

have a portion of your disposable income go directly
into your savings account. Saving becomes effortless,
while spending actually requires a more conscious
effort. © 2010 Jupiterimages
Corporation
Some savings accounts need to be “segregated” because

of different tax consequences—a retirement or
education account, for example. In most cases, however,
separating accounts by their intended use has no real financial value, although it
can create a psychological benefit. Establishing a savings vehicle has a very low
cost, if any, so it is easy to establish as many separate funds for saving as you find
useful.
KEY TAKEAWAYS
• Banks serve to provide the consumer with excess cash by having the
cash earn money through savings until the consumer needs it.
• Banking institutions include retail, commercial, and investments banks.
• Consumers use retail institutions, including the following:
◦ Savings banks
◦ Mutual savings banks
◦ Savings and loan associations
◦ Credit unions
• Savings instruments include the following:
◦ Demand deposit accounts

◦ Time deposit accounts
◦ Certificates of deposit
◦ Money market mutual fund accounts
• A savings strategy can maximize your earnings from savings.

EXERCISES
1. Record your experiences with certificates of deposit (CDs) and money

market mutual funds (MMMFs). What are the benefits and drawbacks of
these instruments for saving? Compared to savings accounts, what are
their implications for liquidity and risk? What are their implications for
cost and return? What advice would you give to someone who saved by
keeping money in a piggy bank?
2. You have $10,000 to deposit. You want to save it, earning interest by
loaning its use in the money market to your bank. You anticipate you
will need to replace your washing machine within the year, however, so
you don’t want to surrender all your liquidity all at once. What is the
best way to save your money that will give you the greatest increase in
wealth without too much risk and while still retaining some liquidity?
Explain your reasons for your choice of a solution.
3. View the four videos in Donna Freedman’s series for MSN “Living Poor
and Loving It,” and read her related articles
(http://articles.moneycentral.msn.com/SmartSpending/
FindDealsOnline/living-poor-and-loving-it-donna-freedman-
video.aspx?page=all). The videos track her experiments with living
frugally to save enough money to finance her college education as an
older student. What four basic strategies does Freeman employ in her
quest? Which, if any, of these strategies have you tried or would you try,
and why? What are some other strategies you have tried for living
frugally to achieve a particular financial goal? Share these strategies
with classmates.
4. Donna Freedman’s strategies for saving relate more to spending than to
saving. Considering that we don’t know what instruments for saving she
used, what other strategies for saving could you recommend to her, and
why? Record your answers in My Notes or your personal finance journal.
5. Go online to experiment with compound interest calculators (e.g., see
http://www.moneychimp.com/calculator/
compound_interest_calculator.htm or http://www.webmath.com/
compinterest.html). Use real numbers based on your actual or projected
savings. For example, based on what you have in savings now, how much
could you have in five years? To see the effects of compounding,
compare your results with the same calculation for simple interest
(rather than compounded interest), using the calculator at
http://www.webmath.com/simpinterest.html.

7.3 Other People’s Money: Credit
LEARNING OBJECTIVES
1. Identify the different kinds of credit used to finance expenses.

2. Analyze the costs of credit and their relationships to risk and liquidity.
3. Describe the credit rating process and identify its criteria.
4. Identify common features of a credit card.
5. Discuss remedies for credit card trouble.
6. Summarize government’s role in protecting lenders and borrowers.
“Credit” derives from the Latin verb credere (to believe). It has several meanings as a
verb in common usage—to recognize with respect, to acknowledge a
contribution—but in finance, it generally means to allow delayed payment.
Both credit and debt are forms of borrowing. Credit is distinguished from debt in
both its purpose and duration or timing, although in casual conversation the words
are used interchangeably. Credit is used to purchase goods and services, to finance
living expenses, or to make payments more convenient by delaying them for a
relatively short time. Debt, on the other hand, is used to finance the purchase of
assets—such as a car or a home—rather than to delay payment of recurring
expenses.
The costs of credit and of debt are likewise different, given their different uses and
time horizons. Often, people get into some trouble when they cannot distinguish
between the two and choose the wrong form of financing at the wrong time. Figure
7.6 "Credit versus Debt" distinguishes credit from debt.
Figure 7.6 Credit versus Debt
217
Kinds of Credit
Credit is issued either as installment credit or as revolving credit. Installment

credit15 is typically issued by one vendor, such as a department store, for a specific
purchase. The vendor screens the applicant and extends credit, bearing the default
risk16, or risk of nonpayment. Payments are made until that amount is paid for.
Payments include a portion of the cost of the purchase and the cost of the credit
itself, or interest.
Installment credit is an older form of credit that became popular for the purchase
of consumer durables (i.e., furniture, appliances, electronics, or household items)
after the First World War. This form of credit expanded as mass production and
invention made consumer durables such as radios and refrigerators widely
available. (Longer-term installment purchases for bigger-ticket assets, such as a car
or property, are considered debt.)
Revolving credit17 extends the ability to delay payment for different items from
different vendors up to a certain limit. Such credit is lent by a bank or finance
company, typically through a charge card18 or a credit card19. The charge card
balance must be paid in full in each period or credit cycle20, while the credit card
balance may not be, requiring only a minimum payment.
The credit card is a more recent form of credit, as its use became widely practical
only with the development of computing technology. The first charge card was the
15. A form of credit used to Diners’ Club card, issued in 1950. The first credit card was the Bank Americard (now
purchase consumer durables,
usually issued by one vendor called Visa), issued by Bank of America in 1958, which was later followed by
for one item. MasterCard in 1966. Retailers can also issue revolving credit (e.g., a store account or
credit card) to encourage purchases.
16. The risk that a borrower will
not be able to meet interest
obligations or principal
repayment.
Credit cards are used for convenience and security. Merchants worldwide accept
credit cards as a method of payment because the issuer (the bank or finance
17. A form of credit used to company) has assumed the default risk by guaranteeing the merchants’ payment.
purchase consumer durables
issued by a bank of finance
Use of a credit card abroad also allows consumers to incur less transaction cost.
company to purchase many
items from many vendors.
This universal acceptance allows a consumer to rely less on cash, so consumers can
18. Revolving credit that must be carry less cash, which therefore is less likely to be lost or stolen. Credit card
periodically paid in full.
payments also create a record of purchases, which is convenient for later record
19. Revolving credit that may not keeping. When banks and finance companies compete to issue credit, they often
be paid in full, creating an offer gifts or rewards to encourage purchases.
interest expense.
20. The time period for extending

and paying credit.
7.3 Other People’s Money: Credit 218

Credit cards create security against cash theft, but they

also create opportunities for credit fraud and even for Figure 7.7
identity theft. A lost or stolen credit card can be used to
extend credit to a fraudulent purchaser. It can also
provide personal information that can then be used to
assume your financial identity, usually without your
knowing it. Therefore, handle your credit cards
carefully and be aware of publicized fraud alerts. Check
your credit card statements for erroneous or fraudulent
charges and notify the issuer immediately of any © 2010 Jupiterimages
discrepancies, especially if the card is lost or stolen. Corporation
Failure to do so may leave you responsible for purchases
you did not make—or enjoy.
Costs of Credit
Credit has become a part of modern transactions, largely enabled by technology,

and a matter of convenience and security. It is easy to forget that credit is a form of
borrowing and thus has costs. Understanding those costs helps you manage them.
Because consumer credit is all relatively short term, its cost is driven more by risk
than by opportunity cost, which is the risk of default or the risk that you will fail to
repay with the amounts advanced to you. The riskier the borrower seems to be, the
fewer the sources of credit. The fewer sources of credit available to a borrower, the
more credit will cost.
Measuring Risk: Credit Ratings and Reports
How do lenders know who the riskier borrowers are?
Credit rating21 agencies specialize in evaluating borrowers’ credit risk or default

risk for lenders. That evaluation results in a credit score22, which lenders use to
determine their willingness to lend and their price.
21. An analysis of personal
creditworthiness based on
income, current credit and If you have ever applied for consumer credit (a revolving, installment, or personal
debt, and credit history. The loan) you have been evaluated and given a credit score. The information you write
assessment is done by a credit
on your credit application form, such as your name, address, income, and
rating agency that makes the
credit report available to employment, is used to research the factors for calculating your credit score, also
lenders. known as a FICO (Fair Isaac Corporation) score after the company that developed it.
22. A numerical score that rates
personal creditworthiness in
the credit rating process.

In the United States, there are currently three major credit rating agencies:
Experian, Equifax, and TransUnion. Each calculates your score a bit differently, but
the process is common. They assign a numerical value to five characteristics of your
financial life and then compile a weighted average score. Scores range from 300 to
900; the higher your score, the less risky you appear to be. The five factors that
determine your credit score are
1. your payment history,

2. amounts you currently owe,
3. the length of credit history,
4. new credit issued to you,
5. the types of credit you have received.
The rating agencies give your payment history the most weight, because it indicates
your risk of future defaults. Do you pay your debts? How often have you defaulted
in the past?
The credit available to you is reflected in the amounts you currently owe or the
credit limits on your current accounts. These show how dependent you are on
credit and whether or not you are able to take on more credit. Generally, your
outstanding credit balances should be no more than 25 percent of your available
credit.
The length of your credit history shows how long you

have been using credit successfully; the longer you have Figure 7.8
been doing so, the less risky a borrower you are, and the
higher your score becomes. Credit rating agencies pay
more attention to your more recent credit history and
also look at the age and mix of your credit accounts,
which show your consistency and diversification as a
borrower.
The credit rating process is open to manipulation and © 2010 Jupiterimages

Corporation
misinterpretation. Many people are shocked to discover,
for example, that simply canceling a credit card, even
for a dormant or unused account, lowers their credit
rating by shortening their credit history and decreasing
the diversity of their accounts. Yet, it may make sense for a responsible borrower to
cancel a card. Credit reports may also contain errors that you should correct by
disputing the information.

You should know your credit score. Even if you haven’t applied for new credit, you
should check on it annually. Each of the three agencies is required to provide your
score once a year for free and to correct any errors that appear—and they do—in a
timely way. If you should find an error in your report, you should contact the
agency immediately and follow up until the report is corrected.
Order your free annual credit report from the three credit reporting agencies at
https://www.annualcreditreport.com/cra/index.jsp. (Beware of any other Web
sites called “annual credit report” as these may be impostors.) It is important to
check your score regularly to check for those errors. Knowing your score can help
you to make financing decisions because it can help you to determine your
potential costs of credit. It can also alert you to any credit or identity theft of which
you otherwise are unaware.
Identity theft23 is a growing problem. Financial identity theft occurs when

someone poses as you based on having personal information such as your Social
Security number, driver’s license number, bank account number, or credit card
numbers. The impostor uses your identity to either access your existing accounts
(withdrawing funds from your checking account or buying things with your credit
card) or establish new accounts in your name and use those.
The best protection is to be careful how you give out public information.
Convenience encourages more and more transactions by telephone and Internet,
but you still need to be sure of whom you are talking to before giving out
identifying data.
As careful as you are, you cannot protect yourself completely. However, checking
your credit report regularly can flag any unfamiliar or unusual activity carried out
in your name. If you suspect that your personal information has been breached, you
can ask the credit reporting agencies to issue a fraud alert. Fraud alert messages
notify potential credit grantors to verify your identification by contacting you
before extending credit in your name in case someone is using your information
without your consent. That way, if a thief is using your credit to establish new
accounts (or buy a home, a car, or a boat) you will know it. If a stronger measure is
needed, you can order a credit freeze that will prevent anyone other than yourself
from accessing your credit file.
23. A fraud that occurs when the
identity is used to access or
create accounts for financial
Using a Credit Card
gain.
24. The time between the purchase

Credit cards issued by a bank or financing company are the most common form of
date and the date that interest revolving credit. This often has costs only after a repayment deadline has passed.
is charged on revolving credit. For example, many credit cards offer a grace period24 between the time of the

credit purchase or “charge” and the time of payment, assuming your beginning
balance is zero. If you pay before interest is applied, you are using someone else’s
money to make your purchases at no additional cost. In that case, you are using the
credit simply as a cash management tool.
Credit cards are effective as a cash management tool. They can be safer to use than
cash, especially for purchasing pricier items. Payment for many items can be
consolidated and made monthly, with the credit card statement providing a
detailed record of purchases. If you carry more than one card, you might use them
for different purposes. For example, you might use one card for personal purchases
and another for work-related expenses. Credit cards also make it convenient to buy
on impulse, which may cause problems.
Problems arise if you go beyond using your card as a cash management tool and use
it to extend credit or to finance your purchases past the payment deadline. At that
point, interest charges begin to accrue. Typically, that interest is
expensive—perhaps only a few percentage points per month, but compounding to a
large annual percentage rate (APR).
Credit card APRs today may start with 0 percent for introductory offers and range
from 8.75 percent to more than 20 percent. These rates may be fixed or variable,
but in any case, when you carry a balance from month to month, this high interest
is added to what you owe.
As an example, if your credit card charges interest of 1.5 percent per month, that
may not sound like much, but it is an annual percentage rate of 18 percent (1.5% per
month × 12 months per year). To put that in perspective, remember that your
savings account is probably earning only around 1 to 3 percent per year. Consumer
credit thus is an expensive way to finance consumption. Consumers tend to rely on
their cards when they need things and lack the cash, and this can quickly lead to
credit card debt.
According to recent surveys, 41 percent of college students have a credit card, and
of those, about 65 percent pay their bills in full every month. This is higher than the
general adult population, and fewer than half of U.S. families carry credit card
debt.Federal Reserve Survey of Consumer Finances, February 2009,
http://www.federalreserve.gov/PUBS/oss/oss2/scfindex.html (accessed February
11, 2009). Among the 35 percent of college students with credit cards who do not
pay their balances in full every month, the average balance is $452.Student Monitor
annual financial services study, 2008.

Choosing a Credit Card
You should shop around for credit just as you would shop around for anything that
you might purchase with it: compare the features and the costs of each credit card.
Features of the credit include the credit limit (or how much credit will be
extended), the grace period, purchase guarantees, liability limits, and consumer
rewards. Some cards offer a guarantee for purchases; if you purchase a defective
item, you can have the charge “stopped” and removed from your credit card bill.
Liability limits involve your responsibilities should your card be lost or stolen.
Consumer rewards may be offered by some credit cards, usually by rewarding

“points” for dollars of credit. The points may then be cashed in for various
products. Sometimes the credit card is sponsored by a certain retailer and offers
rewards redeemable only through that store. A big sponsor of rewards has been the
airline industry, commonly offering “frequent flyer miles” through credit cards as
well as actual flying. Be aware, however, that many rewards offers have limitations
or conditions on redemption. In the end, many people never redeem their rewards.
Creditors charge fees for extending credit. There is the APR on your actual credit,
which may be a fixed or adjustable rate. It may be adjustable based on the age of
your balance—that is, the rate may rise if your balance is over sixty days or ninety
days. There may also be a late fee charged in addition to the actual interest. The
APR may also adjust as your balance increases, so that even if you stay within your
credit limit, you are paying a higher rate of interest on a larger balance.
There are also fees on cash advances and on balance transfers (i.e., having other
credit balances transferred to this creditor). These can be higher than the APR and
can add a lot to the cost of those services. You should be aware of those costs when
making choices. For example, it can be much cheaper to withdraw cash from an
ATM using your bank account’s debit card than using a cash advance from your
credit card.
Many credit cards charge an annual fee just for having the credit card, regardless of
how much it is used. Many do not, however, and it is worth looking for a card that
offers the features that you want with no annual fee.
How you will use the credit card will determine which features are important to you
and what costs you will have to pay to get them. If you plan to use the credit card as
a cash management tool and pay your balance every month, then you are less
concerned with the APR and more concerned about the annual fee, or the cash

advance charges. If you sometimes carry a balance, then you are more concerned
with the APR.
It is important to understand the costs and responsibilities of using credit—and it is

very easy to overlook them.
Installment Credit
Retailers also may offer credit, usually as installment

Figure 7.9
credit for a specific purchase, such as a flat screen TV or
baby furniture. The cost of that credit can be hard to
determine, as the deal is usually offered in terms of
“low, low monthly payments of only…” or “no interest
for the first six months.” To find the actual interest rate
you would have to use the relationships of time and
value. Ideally, you would pay in as few installments as
you could afford and would pay all the installments in
the shortest possible time.
Retailers usually offer credit for the same reason they

offer home delivery—as a sales tool—because most
often, customers would be hesitant or even unable to
make a durable goods purchase without the opportunity
to buy it over time. For such retailers, the cost of issuing Corporation
and collecting credit and its risk are operating costs of
sales. The interest on installment credit offsets those
sales costs. Some retailers sell their installment
receivables to a company that specializes in the
management and collection of consumer credit, including the repossession of
durable goods.
Personal Loans
Aside from installment credit and rotating credit, another source of consumer
credit is a short-term personal loan arranged through a bank or finance company.
Personal loans used as credit are all-purpose loans that may be “unsecured”—that
is, nothing is offered as collateral—or “secured.” Personal loans used as debt
financing are discussed in the next section. Personal loans used as credit are often
costly and difficult to secure, depending on the size of the loan and the bank’s risks
and costs (screening and paperwork).

A personal loan may also be made by a private financier who holds personal
property as collateral, such as a pawnbroker in a pawnshop. Typically, such loans
are costly, usually result in the loss of the property, and are used by desperate
borrowers with no other sources of credit. Today, many “financiers” offer personal
loans online at very high interest rates with no questions asked to consumers with
bad credit. This is a contemporary form of “loan sharking,” or the practice of
charging a very high and possibly illegal interest rate on an unsecured personal
loan. Some loan sharks have been known to use threats of harm to collect what is
owed.
One form of high-tech loan sharking growing in popularity on the Internet today is
the “payday loan25,” which offers very short-term small personal loans at high
interest rates. The amount you borrow, usually between $500 and $1,500, is directly
deposited into your checking account overnight, but you must repay the loan with
interest on your next payday. The loan thus acts as an advance payment of your
wages or salary, so when your paycheck arrives, you have already spent a large
portion of it, and maybe even more because of the interest you have to pay. As you
can imagine, many victims of repeated payday loans fall behind in their payments,
cannot meet their fixed living expenses on time, and end up ever deeper in debt.
Personal loans are the most expensive way to finance recurring expenses, and
almost always create more expense and risk—both financial and personal—for the
borrower.
Credit Trouble and Protections
As easy as it is to use credit, it is even easier to get into trouble with it. Because of
late fees and compounding interest, if you don’t pay your balance in full each
month, it quickly multiplies and becomes more difficult to pay. It doesn’t take long
for the debt to overwhelm you.
If that should happen to you, the first thing to do is to try to devise a realistic
budget that includes a plan to pay off the balance. Contact your creditors and
explain that you are having financial difficulties and that you have a plan to make
your payments. Don’t wait for the creditor to turn your account over to a debt
collector; be proactive in trying to resolve the debt. If your account has been turned
over to a collector, you do have some protections: the Fair Debt Collection Practices
(federal) law keeps a collector from calling you at work, for example, or after 9 p.m.
25. A small, short-term personal

You may want to use a credit counselor to help you create a budget and negotiate
loan that charges a high rate of with creditors. Many counseling agencies are nonprofit organizations that can also
interest. help with debt consolidation and debt management. Some “counselors” are little

more than creditors trying to sell you more credit, however, so be careful about
checking their credentials before you agree to any plan. What you need is more
realistic credit, not more credit.
As a last resort, you may file for personal bankruptcy, which may relieve you of
some of your debts, but will blemish your credit rating for ten years, making it very
difficult—and expensive—for you to use any kind of credit or debt. Federal
bankruptcy laws allow you to file under Chapter 7 or under Chapter 13. Each allows
you to keep some assets, and each holds you to some debts. Chapter 7 requires
liquidation of most of your assets, while Chapter 13 applies if you have some
income. It gets complicated, and you will want legal assistance, which may be
provided by your local Legal Aid Society. The effects of a bankruptcy can last longer
than your debts would have, however, so it should never be seen as an “out” but
really as a last resort.
Modern laws and regulations governing the extension and use of credit and debt try
to balance protection of the lender and of the borrower. They try to insure that
credit or debt is used for economic purposes and not to further social or political
goals. They try to balance borrowers’ access to credit and debt as tools of financial
management with the rights of property owners (lenders).
In the United States, federal legislation reflects this balance of concerns. Major
federal legislation in the United States is shown in Figure 7.10 "Major U.S. Federal
Legislation: Credit and Debt".
Figure 7.10 Major U.S. Federal Legislation: Credit and Debt

In addition, many states have their own legislation and oversight. Not
coincidentally, most of these laws were written after use of credit cards, and thus
credit, became widespread. The set of laws and regulations that governs banking,
credit, and debt markets has evolved over time as new practices for trading money
are invented and new rules are seen as necessary. You should be aware of the
limitations on your own behavior and on others as you trade in these markets.
If you feel that your legal rights as a borrower or lender have been ignored and that
the offender has not responded to your direct, written notice, there are local, state,
and national agencies and organizations for assistance. There are also organizations
that help borrowers manage credit and debt.
Laws and regulations can govern how we behave in the credit and debt markets, but
not whether we choose to participate as a lender or as a borrower: whether we use
credit to manage cash flow or to finance a lifestyle, whether we use debt to finance
assets or lifestyle, and whether we save. Laws and regulations can protect us from
each other, but they cannot protect us from ourselves.

KEY TAKEAWAYS
• Credit is used as a cash management tool or as short-term financing for

consumption.
• Credit may be issued as revolving credit (credit cards), installment
credit, or personal loans.
• Credit can be a relatively expensive method of financing.
• Credit accounts differ by the following features:
◦ Credit limit
◦ Grace period
◦ Purchase guarantees
◦ Liability limits
◦ Consumer rewards
• Credit accounts charge fees, such as the following:
◦ Annual percentage rate (APR)

◦ Late fees
◦ Balance transfer fees
◦ Cash advance fees
• Credit remedies include the following:
◦ Renegotiation
◦ Debt consolidation
◦ Debt management
◦ Bankruptcy
• Modern laws governing the uses of credit and debt try to balance
protection of borrowers and lenders.

EXERCISES
1. Read the statistics about personal credit card debt at

http://www.creditcards.com/credit-card-news/credit-card-industry-
facts-personal-debt-statistics-1276.php#debt. Record in My Notes or in
your personal finance journal all the facts that pertain especially to you
in your present financial situation. What facts did you find most
surprising or most disturbing? Share your observations about these data
with your classmates.
2. Investigate online the sources and processes of debt consolidation.
Sample the Web sites of debt consolidation businesses offering “free”
advice and services (e.g., http://www.debtconsolidationcare.com/). Are
they free? Now visit the National Center for Credit Counseling (NFCC) at
http://www.nfcc.org/. When seeking advice about your credit, why
might you want to use an NFCC advisor or consumer center?
3. Read the MSN Money Central article “Your Three Worst Debt
Consolidation Moves” at http://moneycentral.msn.com/content/
Savinganddebt/Managedebt/P36230.asp. According to this article, what
are the three worst moves you can make to manage your debt? How can
you consolidate your debt on your own?
4. Go to the U.S. Department of Education site on loan consolidation at
http://www.loanconsolidation.ed.gov/. How can you consolidate your
federal loans directly online with the U.S. government? Use the
worksheets at this site to explore your real or hypothetical options as
the recipient of federal student loans. For example, what would be the
direct consolidation interest rate on your current federal student loans,
and what would your payments be?
5. What is your credit rating or credit score? Apply for your three
credit reports from Equifax (http://www.equifax.com),
TransUnion (http://www.transunion.com), and Experian
(http://www.experian.com). You can apply for all three at once
from one source for free once each year, at
https://www.annualcreditreport.com/. To ensure that you go to
the legitimate site, type this URL directly into the address bar in
your browser window.
a. How do the three reports vary? Is the information accurate?

b. How can you correct the information? For example, see
http://www.equifax.com/answers/correct-credit-report-
errors/en_cp.

c. What are your rights regarding your credit reports? Read

about your rights at http://www.ftc.gov/bcp/menus/
consumer/credit/rights.shtm. What does the video on that
site warn you against? You will find a summary of your
rights under the Fair Credit Reporting Act at
http://www.ftc.gov/bcp/edu/pubs/consumer/credit/
cre35.pdf. Find out if your state guarantees other rights or
additional protections. Take steps now to correct your credit
reports.
6. Research online how you can repair your credit history and improve
your credit rating. Go to http://www.ftc.gov/bcp/edu/pubs/consumer/
credit/cre13.shtm, and see http://www.ehow.com/how_4757_repair-
credit-history.html.

7.4 Other People’s Money: An Introduction to Debt
LEARNING OBJECTIVES
1. Define debt and identify its uses.

2. Explain how default risk and interest rate risk determine the cost of
debt.
3. Analyze the appropriate uses of debt.
Debt is long-term credit, or the ability to delay payment over several periods. Credit
is used for short-term, recurring expenses, whereas debt is used to finance the
purchase of long-term assets. Credit is a cash management tool used to create
security and convenience, whereas debt is an asset management tool used to create
wealth. Debt also creates risk.
Two most common uses of debt by consumers are car loans and mortgages. They
are discussed much more thoroughly in Chapter 8 "Consumer Strategies" and
Chapter 9 "Buying a Home". Before you get into the specifics, however, it is good to
know some general ideas about debt.
231
Usually, the asset financed by the debt can serve as

collateral for the debt, lowering the default risk for the Figure 7.11
lender. However, that security is often outweighed by
the amount and maturity of the loan, so default risk
remains a serious concern for lenders. Whatever
concerns lenders will be included in the cost of debt,
and so these things should also concern borrowers.
Lenders face two kinds of risk: default risk, or the risk of

not being paid, and interest rate risk26, or the risk of
not being paid enough to outweigh their opportunity
cost and make a profit from lending. Your costs of debt
will be higher than the lender’s cost of risk. When you
lower the lender’s risk, you lower your cost of debt.
Costs of Debt
Default Risk
Lenders are protected against default risk by screening

applicants to try to determine their probability of
defaulting. Along with the scores provided by credit
rating agencies, lenders evaluate loan applicants on
“the five C’s”: character, capacity, capital, collateral,
and conditions.
Character is an assessment of the borrower’s attitude © 2010 Jupiterimages

toward debt and its obligations, which is a critical factor Corporation
in predicting timely repayment. To deduce “character,”
lenders can look at your financial stability, employment
history, residential history, and repayment history on
prior loans.
Capacity represents your ability to repay by comparing the size of your proposed
debt obligations to the size of your income, expenses, and current obligations. The
larger your income is in relation to your obligations, the more likely it is that you
are able to meet those obligations.
Capital is your wealth or asset base. You use your income to meet your debt
payments, but you could use your asset base or accumulated wealth as well if your
26. The risk that a bond’s market income falls short. Also, you can use your asset base as collateral.
value will be affected by a
change in interest rates.
7.4 Other People’s Money: An Introduction to Debt 232

Collateral insures the lender against default risk by claiming a valuable asset in case
you default. Loans to finance the purchase of assets, such as a mortgage or car loan,
commonly include the asset as collateral—the house or the car. Other loans, such as
a student loan, may not specify collateral but instead are guaranteed by your
general wealth.
Conditions refer to the lender’s assessment of the current and expected economic
conditions that are the context for this loan. If the economy is contracting and
unemployment is expected to rise, that may affect your ability to earn income and
repay the loan. Also, if inflation is expected, the lender can expect that (1) interest
rates will rise and (2) the value of the currency will fall. In this case, lenders will
want to use a higher interest rate to protect against interest rate risk and the
devaluation of repayments.
Interest Rate Risk
Because debt is long term, the lender is exposed to interest rate risk, or the risk that
interest rates will fluctuate over the maturity of the loan. A loan is issued at the
current interest rate, which is “the going rate” or current equilibrium market price
for liquidity. If the interest rate on the loan is fixed, then that is the lender’s
compensation for the opportunity cost or time value of money over the maturity of
the loan.
If interest rates increase before the loan matures, lenders suffer an opportunity cost
because they miss out on the extra earnings that their cash could have earned had
it not been tied up in a fixed-rate loan. If interest rates fall, borrowers will try to
refinance or borrow at lower rates to pay off this now higher-rate loan. Then the
lender will have its liquidity back, but it can only be re-lent at a newer, lower price
and create earnings at this new, lower rate. So the lender suffers the opportunity
cost of the interest that could have been earned.
27. A loan for which the interest Why should you, the borrower, care? Because lenders will have you cover their
rate can change, usually
costs and create a loan structured to protect them from these sorts of risks.
periodically and relative to a
benchmark rate such as the Understanding their risks (looking at the loan agreement from their point of view)
prime rate. helps you to understand your debt choices and to use them to your advantage.
28. A loan for which the interest
rate remains constant over the Lenders can protect themselves against interest rate risk by structuring loans with
maturity of the loan.
a penalty for early repayment to discourage refinancing or by offering a floating-
29. A benchmark interest rate rate loan27 instead of a fixed rate-loan28. With a floating-rate loan, the interest
understood to be the rate that rate “floats” or changes, usually relative to a benchmark such as the prime rate29,
major banks charge corporate
borrowers with the least which is the rate that banks charge their very best (least risky) borrowers. The
default risk. floating-rate loan shifts some interest rate risk onto the borrower, for whom the

cost of debt would rise as interest rates rise. The borrower would still benefit, and
the lender would still suffer from a fall in interest rates, but there is less probability
of early payoff should interest rates fall. Mainly, the floating-rate loan is used to
give the lender some benefit should interest rates rise. Figure 7.12 "U.S. Prime Rate
1975–2008" shows the extent and frequency of fluctuations in the prime rate from
1975–2008.
Figure 7.12 U.S. Prime Rate 1975–2008Data from the U.S. Federal Reserve, http://federalreserve.gov/releases/
h15/data/Monthly/H15_PRIME_NA.txt (accessed February 11, 2009).
Borrowers may be better off having a fixed-rate loan and having stable and
predictable payments over the life of the loan. The better or more creditworthy a
borrower you are, the better the terms and structure of the loan you may negotiate.
Uses of Debt
Debt should be used to finance assets rather than recurring expenses, which are
better managed with a combination of cash and credit. The maturity of the
financing (credit or debt) should match the useful life of the purchase. In other
words, you should use shorter-term credit for consumption and longer-term debt
for assets.

If you finance consumption with longer-term debt, then

your debt will outlive your expenses; you will be Figure 7.13
continuing to pay for something long after it is gone. If
you finance assets with short-term debt, you will be
making very high payments, both because you will be
repaying over a shorter time and so will have fewer
periods in which to repay and because your cost of
credit is usually higher than your cost of debt, for
example, annual credit card rates are typically higher
than mortgage rates.
Borrowers may be tempted to finance asset purchases

with credit, however, to avoid the more difficult
screening process of debt. Given the more significant
investment of time and money in debt, lenders screen
potential borrowers more rigorously for debt than they © 2010 Jupiterimages
do for credit. The transaction costs for borrowing with Corporation
debt are therefore higher than they are for borrowing
with credit. Still, the higher costs of credit should be a
caution to borrowers.
The main reason not to finance expenses with debt is that expenses are expected to
recur, and therefore the best way to pay for them is with a recurring source of
financing, such as income. The cost of credit can be minimized if it is used merely as
a cash management tool, but if it is used as debt, if interest costs are allowed to
accrue, then it becomes a very costly form of financing, because it creates new
expense (interest) and further obligates future income. In turn, that limits future
choices, creating even more opportunity cost.
Credit is more widely available than debt and therefore is a tempting source of
financing. It is a more costly financing alternative, however, in terms of both
interest and opportunity costs.

KEY TAKEAWAYS
• Debt is an asset management tool used to create wealth.

• Costs of debt are determined by the lender’s costs and risks, such as
default risk and interest rate risk.
• Default risk is defined by the borrower’s ability to repay the interest and
principal.
• Interest rate risk is the risk of a change in interest rates that affects the
value of the loan and the borrower’s behavior.
• Debt should be used to purchase assets, not to finance recurring
expenses.
EXERCISES
1. Identify and analyze your debts. What assets secure your debts? What
assets do your debts finance? What is the cost of your debts? What
determined those costs? What risks do you undertake by being in debt?
How can being in debt help you build wealth?
2. Are you considered a default risk? How would a lender evaluate you
based on “the five C’s” of character, capacity, capital, collateral, and
conditions? Write your evaluations in your personal finance journal or
My Notes. How could you plan to make yourself more attractive to a
lender in the future?
3. Discuss with classmates the Tim Clue video on debt at
http://karenblundell.com/funny/funny-video-debt. What makes this
comedy spot funny? What makes it not funny? What does it highlight
about the appropriate uses of debt?

Chapter 8
Consumer Strategies
Introduction
Reva, Burt, and Kim are all students at the local state college. All are living at home
to save money while in school, and all are working at least one job to pay tuition.
Between their paychecks and financial aid, they can get by, but not by much.
Living in a city with public transportation, none of them

needs a car, but Reva keeps an old beater in her dad’s Figure 8.1
garage. The ace of her tech classes in high school, Reva
loves to get under the hood.
Burt loves nothing more than to get lost in the world of

games; he is hoping that his degree in digital media will
lead to a career developing games and applications for a
growing market. Whenever he can, he upgrades his
laptop and smartphone with the latest killer “apps.”
Kim is hoping to go into business as a fashion designer

and is getting a head start by joining the campus
business club. Wanting to make a good impression, Kim
is careful to maintain a fashionable yet professional
wardrobe. © 2010 Jupiterimages
Corporation
All three are consumers and will be all their lives. All
three make consumption decisions based on their
financial and strategic goals, on their personal tastes
and lifestyle, and on professional choices. Their choices are very different and have
different financial consequences. While there are many aspects of your humanity
that define you, the things that you choose to surround yourself with—or not—may
define your ultimate happiness. You need strategies.
237
Chapter 8 Consumer Strategies
8.1 Consumer Purchases
LEARNING OBJECTIVES
1. Trace the prepurchase, purchase, and postpurchase steps in consumer

purchases.
2. Demonstrate the use of product-attribute scoring in identifying the
product.
3. Compare and contrast features of different consumer markets.
4. Analyze financing choices and discuss their impact on purchasing
decisions.
5. Discuss the advantages of consumer strategies using branding, timing,
and transaction costs.
6. Identify common consumer scams, strategies, and remedies.
Consumer purchases refer to items used in daily living (e.g., clothing, food,
electronics, appliances). They are the purchases that most intimately frame your
life: you live with these items and use them every day. They are an expression and a
reflection of you, your tastes, and your lifestyle choices. Your spending decisions
reflect your priorities. Maybe you take pride in your car or your clothes or your
kitchen appliances or your latest, coolest whatever. Or maybe you spend whatever
you can on travel or on your passion for hiking. Those very personal tastes will
frame your spending choices.
Consumer purchases should fit into your budget. By making an operating budget,
you can plan to consume and to finance your consumption without creating extra
costs of borrowing. You can plan to live within your income. At times, you may have
unexpected changes (loss of a job or change in the family) that put your
nondiscretionary needs temporarily beyond your means. Ideally, you would want to
have a cushion to tide you over until you can adjust your spending to fit your
income.
A budget can also show you just how fast some “small luxuries” can add up.
Stopping for a latte on your way to work or school every day ($3.95) adds up to $20
per week, or about $1,000 per year. That money may be better used to finance a
bigger ticket item that you then would not have to finance with debt. With the
budget to help you put expenses into perspective, you can make better purchasing
decisions.
238
Purchasing decisions are always limited by the income available, and that means
making choices. Your choices of what, where, when, and even how to buy will affect
the amount that you spend and the utility (the joy or regret) that you ultimately get
out of your purchase.
Shopping is a process. You decide what you want, then have to make more specific
decisions:
• Should you buy more (and pay more) but get a cheaper unit price?
• Should you buy locally or remotely, via catalogue or Internet?
• Should you pay more for a well-known brand, or buy the generic?
• Should you look for a guarantee or warranty or consider long-term
repair costs?
• Should you consider resale value?
• Should you pay cash or use credit? If you pay through credit, is it store
credit, your own credit card, or a loan?
Each of these decisions creates a trade-off. For example,

it may be more convenient—and quicker—to shop Figure 8.2
locally, but there may be lower prices and a better
selection of products online. Or you may find lower
prices online but have a harder time getting repairs
done if you haven’t bought locally.
Some of your purchases involve few conscious

decisions—for example, groceries—because you buy
them repeatedly and often. Other purchases involve
more decisions because they are made less often and
involve costlier items such as a car. When you have to
live with your decision for years instead of days, you
tend to make it more carefully.
The decision process can be broken down into the © 2010 Jupiterimages
Corporation
following steps:
• Before you buy or “prepurchase,”
◦ identify the product: compare attributes;

◦ identify the market: compare price, delivery (return), convenience;
◦ identify the financing.
8.1 Consumer Purchases 239

• As you buy,
◦ negotiate attributes: color, delivery, style;

◦ negotiate price and purchase costs;
◦ negotiate payment.
• After you buy, or “postpurchase,” consider
◦ maintenance;
◦ how to address dissatisfaction.
Before You Buy: Identify the Product
What do you want? What do you want it to do for you? What do you want to gain by
having it or using it or wearing it or eating it or playing with it or…? You buy things
hoping to solve a need in your life. The more specifically you can define that need,
the more accurately you can identify something to fill it. If your purchase is
inappropriate for your need, you will not be happy with it, no matter how good it is.
And because your budget is limited, you want to minimize your opportunity cost
and buyer’s remorse1 or regret at not making a better purchase in order to use
your limited income most efficiently.
Sometimes you can identify a need, but have no idea of the kinds of products that
may fill it. This is especially true for infrequent needs or purchases. For example,
you may decide you need to get away and take a long weekend. To do it cheaply,
you decide to go hiking and camping. To make it more fun, you decide to go to an
area where you’ve never been before. You may not be aware of the camping options
available in that area, however, or of equally cheap alternatives such as hostels, bed
and breakfasts, or other accommodations. When you find that you have a range of
choices, you can compare them and choose one that offers the most satisfaction.
Once you have identified the product, you can compare the attributes of those
products. What characteristics do you require or want? How are you going to use
the product? For example, do you need cooking facilities, access to a shower, a safe
but scenic location, opportunities to meet other hikers, and so on? What attributes
are important to you and what are available?
1. Regret following a purchase,

especially common with an
impulse purchase.

Sig is looking for a new computer keyboard, a hot

gaming keyboard that can also be comfortable for Figure 8.3
writing college papers. Sig begins to research keyboards
and finds over five hundred models from over fifty
brands with different designs, attributes, and functions
offered at a range of prices. He decides to try to filter his
choices by looking only at gaming keyboards, which
narrows it down to about eighty models.
Noticing that most of the keyboards range in price from Corporation
twenty-five to fifty dollars, he decides to look in the
fifty to a hundred dollar range, figuring he’ll get a
slightly higher-end product, but not an outrageously
expensive one. This narrows his search to about twenty-five models.
None of the models has all the attributes that Sig desires. It’s a trade-off: he can
have some features, but not others. He decides to try to organize his research by
creating a table ranking the product attributes in order of importance, and then
scoring each model on each attribute (on a scale of one to ten), eventually coming
up with an overall score for each model. Figure 8.4 "Sig’s Product-Attribute
Scoring" shows scoring for three models.
Figure 8.4 Sig’s Product-Attribute Scoring

Multiplying each attribute’s weight by its score gives its weighted score, then
adding up each weighted score gives the total score for the product. Based on this
attribute analysis, Sig would choose TKG, which has the highest overall score.
In the case of an asset purchase, you may eventually think of reselling the item, so
the ease and/or costs of doing so may figure into your prebuying evaluation. You
may decide to go with a “better” product—a more recognizable or popular brand,
for example—that may have a higher resale value. You also need to consider the
market for used or preowned products: if there is one, how liquid the market is, or
how easy it is to use. If the market is not very liquid, then the transaction costs of
selling in the used product market may be significant, and you may be disappointed
with the result.
The more choices you have, the better your chances of finding satisfaction. The
more products there are to satisfy your need, and the more attributes those
products offer, the more likely you are to find what “works” for you. Sometimes
you need to be a bit creative in thinking about your alternatives, especially with
limited resources.
Sources of product information include the manufacturer, retailer, and other

consumers. Certain information must be provided for certain products by law. For
example, food ingredients must be labeled, and perishable products dated.
Appliances almost always come with operating and care instructions that can give
you an idea of their ongoing maintenance costs as well as operating features.
The Internet has made it easy to research products online and to become a much
better informed consumer. You can do lots of research online, even if you actually
purchase locally. A feature of many online stores and consumer discussions is
product reviews, where consumers give feedback on their satisfaction with the
product. Such reviews can balance the information from the manufacturer and
retailer, who want to inform consumers to encourage them to buy.
Other sources of information are magazines and trade journals (such as Consumer
Reports, both in print and online), which have articles and ratings on products as
well as ads. Your research may also involve actual or virtual window shopping, like
going to stores to examine the products you are thinking of buying.

Before You Buy: Identify the Market
Your market may be local, national, or international, with advantages and

disadvantages to each. Generally, a larger market (more vendors) will offer more
variation and selection of product attributes.
As with any market, the real determinant of how your market works is competition.
The more vendors there are, the more they compete for your business, and the
more likely you will find options for purchasing convenience, product attributes,
and price.
In markets where vendors are so plentiful that your problem is filtering rather than
finding information, there are middlemen to provide that service. An example is
the budget travel businesses with Web sites that make it convenient to research and
buy flights, rental cars, and hotel accommodations. Middlemen or brokers2 exist in
markets where they can add value to your purchasing process, either by providing
information in the prepurchase stage or by providing convenience during the
purchase. The more they can reduce the cost of a “bad” decision (e.g., a difficult
flight schedule, an expensive car rental, an uncomfortable hotel accommodation),
the more valuable they are. They can add more value in markets where you have
too little or too much information or less familiarity with products or vendors.
Generally, the more expensive the product or the less frequent the purchase, the
more likely you will find a middleman to make it easier.
Some products have a “new” and a “used” market, such as durable goods and some
consumer goods like textbooks, vintage clothing, and yard sale goods. Evaluating
the quality of a used or preowned product can require more research, information,
and expertise, because the effect of its past use on its future value can be hard to
estimate. Used products are almost always priced less than new products, unless
they have become “collectibles” that can store value. The trade-off is that used
products offer less reliable or predictable future performance and may lack
attributes of newer models.
Different kinds of stores often offer the same products at different prices.
Convenience stores, for example, typically charge higher prices than grocery stores
but may be in more convenient locations and open at more convenient hours.
Smaller boutique stores cannot always realize the economies of scale in
administrative costs or in inventory management that are available to a larger store
or a chain of stores. For those reasons prices tend to be higher at a smaller store.
Boutiques often offer more amenities and a higher level of customer service to be
2. An intermediary that acts as an competitive. You may also shop at a specialty store when you need a certain level of
agent for buyers or sellers to
expertise or assistance in making a purchase.
arrange a trade.

Cooperative stores are owned and managed collectively and may provide goods or
services that would not otherwise be available. Shopping is usually open to anyone,
but members are eligible for discounts, depending on their participation in the
store’s operations or management. The members own the store, so they can forgo
corporate profits for consumer discounts.
Increasingly, merchandise of all kinds may be bought directly from the

manufacturer, often through a catalogue or online. The shopping experience is very
different (you can’t try on the sweater or see how the keyboard feels), but if you are
well informed about the product, you may be comfortable buying it. Internet
shopping has become a great convenience to those who are too busy or too far away
to visit stores.
Auctions are becoming increasingly popular, especially online auctions at eBay and
similar sites. Auctions are open negotiations between buyers and sellers and offer
dynamic pricing. They also offer uncertainty, as the price and even the eventual
purchase are risky—you may lose the auction and not get the item. Auctions are
used most often for resales and for assets such as homes, cars, antiques, art, and
collectibles. The popularity of online auctions has led to more buyers, bringing
more competition and thus higher prices.
Before You Buy: Identify the Financing
Most consumer purchases are for consumable goods or services and are budgeted
from current income. You pay by using cash or a debit card or, if financed, by using
a credit card for short-term financing. Such purchases—food, clothing,
transportation, and so on—should be covered by recurring income because they are
recurring expenses. You need to be able to afford them. As you read in Chapter 7
"Financial Management", consumers who use debt to finance consumption can
quickly run into trouble because they add the cost of debt to their recurring
expenses, which are already greater than their recurring income.
Unless financed by savings, durable goods such as appliances, household wares, or

electronics are often bought on credit, as they are costlier items infrequently
purchased. Assets such as a car or a home may be financed using long-term debt
such as a car loan or a mortgage, although they also require some down payment of
cash.
The use of middlemen or brokers to find and buy an item also contributes to the
cost of a purchase because of the fees you pay for the service.

Products and preferred financing sources are shown in Figure 8.5 "Products and
Preferred Financing Sources".
Figure 8.5 Products and Preferred Financing Sources
As You Buy: The Purchase
Having done your homework and made your choice, you are ready to purchase. In
some cases, you may be able to make specific arrangements with vendors as to
convenience, price, delivery, and even financing.
In Western cultures, prices for consumer goods are usually not negotiable;
consumers expect to pay the price on the price tag. In other cultures, however,
haggling over price is common and expected, which often surprises travelers
abroad.
Durable goods and asset purchases typically offer more purchase options than
consumer goods, usually as an incentive to buyers. Vendors may offer free delivery
or free installation, product guarantees, or financing arrangements such as “no
payments for six months” or “zero percent financing.” Offers may be enhanced
periodically to “move the merchandise,” when prices may also be discounted. Sales,
“special offers” or “low, low prices” may be used to sell merchandise that is about
to be replaced by a newer model. If those product cycles are seasonal and
predictable, you may be able to schedule your purchase to take advantage of
discounts.
Or you may decide to wait and pay full price for the newer model to avoid
purchasing a product that is about to become outdated.

The more the purchase process allows for negotiation, the more possibility there is
for consumers to enhance satisfaction. However, the negotiation process can go the
other way too: it allows more opportunity for the vendor to negotiate an advantage.
The better-informed consumer is more likely to negotiate a more satisfying
purchase, so it is important to be thorough in the prepurchase research.
A purchase may have transaction costs such as sales tax or delivery charges. For
higher-priced products such as durables and assets, those transaction costs can add
up, so you should figure them into your overall cost of the purchase.
Financing costs can also be significant if debt financing is used. Debt is long term
and is a significant commitment as well. It may pay to compare financing rates and
terms just as you would for the product itself, or you may be able to use financing
costs as a negotiating chip in your price negotiations.
After You Buy
Now you can enjoy your purchase. Some products require maintenance and
periodic repair to remain useful. You should research those additional costs before
buying, because after the purchase you are committed to those activities.
If you are not satisfied due to a product defect, you can contact the retailer or
manufacturer. If there is a warranty, the retailer or manufacturer will either fix the
defect or replace the item. Many manufacturers and retailers will do so even if
there is no warranty to maintain good customer relations and enhance their
brand’s reputation. An Internet search will usually turn up contact information for
a product’s customer service team.

There are also federal and state consumer protection

laws that cover a seller’s responsibilities after a sale. In Figure 8.6
the United States, the Federal Trade Commission (FTC)
Bureau of Consumer Protection has the most direct
responsibility for consumer issues. At the state level, the
office of the attorney general usually has a consumer
protection division. Locally, you can also contact your
chamber of commerce or Better Business Bureau (BBB)
for more information.
You can also resort to the judicial system for

compensation. For limited claims, you can file in small
claims court. Claim limits vary by state, but range
between $500 and $10,000. Small claims court is a less
formal and costly process than filing a suit. At the other
end of the spectrum is the class-action suit in which © 2010 Jupiterimages
many plaintiffs pursue the same complaint, sharing the Corporation
costs and the awards of the lawsuit.
Consumer Strategies
The advertising industry is proof of the importance of “branding.” Customer brand

loyalty is a real phenomenon. In 2007, the top 100 biggest advertisers spent
$107,635,000,000 on advertising worldwide, with the automotive, personal care, and
food industries leading the pack.Advertising Age, “Global Marketers: Top 100,”
December 8, 2007, http://adage.com/images/random/datacenter/2008/
globalmarketing2008.pdf (accessed April 1, 2009). Producers go to great expense to
brand their products. When in doubt, consumers tend to choose a familiar brand.
Once disappointed by a brand, consumers tend to avoid it. For some products, there
are alternative private-label or store-label brands, applied to many products but
sold by one store or chain. The store brand is usually a cheaper alternative and
often, although not always, of comparable quality. This is a widespread practice in
the food industry with grocery store brands. Shopping for the store brand can often
yield significant savings.
Aiden’s purchase comes with a two-year manufacturer’s guarantee, but the

salesperson is encouraging her to buy an extended warranty. She is already paying
more than she wanted to for a high-quality machine, and the extended warranty
adds nearly a hundred dollars to the purchase price. She decides to forgo the extra
protection, reasoning that most repairs, if needed after two years, would cost less
than that anyway.

An offer of a warranty with purchase can be valuable if it lowers the expected

maintenance or repair costs of the product. Sometimes a product is offered with a
warranty at a higher price; sometimes you can purchase an optional warranty for
an additional cost. If the cost of a malfunction is low, then the warranty is probably
not worth it.
Price advantage can sometimes come through timing. Seasonally updated products
or models can force retailers to discount old inventory to get it off the shelves
before the new inventory arrives. Automobiles, for example, have a one-year
product cycle, as do many desktop computers and peripherals.
Some products are naturally dated, such as calendars or tax preparation software,
and so may be discounted as they near their expiration date. However, that is
because they have less and less usefulness and may not be worth buying at all.
Commodities prices can fluctuate depending on the season or the weather, and
although you may not have a choice of buying home heating oil when you do, some
products do offer you a choice. Tomatoes in January are more expensive than in
August, for example; eating fresh foods seasonally can produce savings.
Price can also be affected by transaction costs, or the costs of making the purchase.
They can be included in the price or may be listed separately. Larger and more
expensive items tend to have more transaction costs such as delivery and storage.
Sales tax, which is a percentage of the price, may be required, and the higher the
item’s price, the more sales tax you will pay. Asset purchases also involve a legal
transfer of ownership and often the costs of acquiring financing, which add to their
costs. Sometimes, to entice a purchase, the seller may agree to bear some or all of
the transaction costs.
Retailers change prices based on buyers’ needs. They practice price

discrimination3, or the practice of charging a different price for the same product,
when different consumers have different need of a product. Airlines are a classic
example, charging less for a ticket bought weeks in advance than for the same flight
if the ticket is bought the day before. Someone who purchases weeks ahead is
probably a leisure traveler, has more flexibility, and is more sensitive to price.
Someone who books a day ahead is probably a business traveler, has little
flexibility, and is not so sensitive to price. The business traveler, in this case, is
willing to pay more, so the airline will charge that person more.
3. The practice of offering the

same product at a different Retailers also offer discounts, sales, or “deals” to attract consumers who otherwise
price, depending on customer would not be shopping. Sometimes these are seasonal and predictable, such as in
needs.

January, when sales follow the big holiday shopping season. Sometimes sales are
not sales at all, but prices are “discounted” relative to new, higher, prices that will
soon take effect. Quantity discounts4, a lower unit price for a higher volume
purchased, may be available for customers buying larger quantities, although
sometimes the opposite is true, that is, the smaller package offers a smaller unit
price. While it may be cheaper to buy a year’s worth of toilet paper at one time, you
then create storage costs and sacrifice liquidity, which you should weigh against
your cost savings.
In short, sellers want to sell and will use price to make products more attractive. As
a buyer, you need to recognize when that attraction offers real value.
Scams: Caveat Emptor (Buyer Beware)
Unfortunately the world of commerce includes people with less-than-honorable

intentions. You likely have been taken advantage of once or twice or have fallen
victim to a scam5, or a fraudulent business activity or swindle. Technology has
made it easier for con artists to steal from more people, contacting them by
telephone or by e-mail. The details of the scam vary, but the pattern is much the
same: the fraud sets up a scenario that requires the victim to send money or to
divulge financial or personal information, such as bank account, Social Security
(federal ID), or credit card numbers, which can then be used to access accounts.
Here are some typical scams reported by Consumer Reports, the magazine of the
nonprofit Consumers Union, an advocacy group for consumers:Consumer Reports,
“Sneakiest Consumer Scams,” September 2007, http://www.consumerreports.org
(accessed April 1, 2009).
• This car’s a cream puff.

• You’ve just won.… Figure 8.7
• There’s a problem with your bank account.
• This stock is at 50 cents, and it’s going to 5
or 6 bucks this week. Buy now!
• You don’t need a physical to qualify for this
low-cost health insurance!
• I’ll be back sometime soon to finish your
roof.
4. The practice of offering a • This investment provides the guaranteed © 2010 Jupiterimages
different unit price for the
high returns and low risk that seniors like Corporation
same product, depending on
quantity purchased. you need.
• We move u 4 less.
5. A scam (confidence game or
con) is a fraud based on trust.

• I’m a political refugee. Help me move millions out of my former

country into your bank account.
• I wouldn’t go on vacation without this car repair.
The best way to protect yourself from scams is to be as informed as possible. Do

your homework. If you feel like you are in over your head, call on a friend or family
member to help you or to speak for you in negotiations. There are a number of
nonprofit and government agencies that you can ask about the legitimacy of an idea
or an arrangement. There are also some proven ways to try to protect yourself:
• Never give anyone personal and/or financial information when

solicited by telephone or Internet. Legitimate business interests do not
do that. When in doubt, contact the organization to verify their
identity.
• Get a second opinion, especially when advised to do costly repairs.
• Check the credentials of prospective workers or service providers;
most are certified, licensed, or recognized by a professional
organization or trade group (e.g., auto mechanics may be endorsed by
the American Automobile Association [AAA]).
• If you have doubts about a professional’s credentials, such as an
accountant, doctor, or architect, call the local professional society or
trade group and ask about previous complaints lodged against him or
her.
• Get a written estimate, specifying the work to be done, the materials to
be used, the estimated labor costs, the estimated completion date, and
the estimated total price. Ask the vendor to provide proof of insurance.
If you do get “scammed,” it is your civic duty to complain to your state’s consumer
division in the attorney general’s office and, if advised, to federal regulators at the
Federal Trade Commission (FTC). That is the only way to stop and expose such
frauds and to keep others from becoming victims. As the saying goes, “If it sounds
too good to be true, it probably is.”

KEY TAKEAWAYS
• The consumer purchase process involves
◦ Prepurchase
▪ Identifying the product

▪ Identifying the market
▪ Identifying the financing
◦ Purchase
▪ Negotiating the purchase price and terms of sale
◦ Postpurchase
▪ Ensuring satisfaction.
• Attribute scoring can be used to help identify the product.

• A product may be sold in different markets that may affect the cost of
the purchase.
• Financing choices can affect the cost of the purchase.
• Strategies such as maximizing the advantages of branding, timing, and
transaction costs can benefit consumers.
• There are common features of scams and also legal protections and
remedies.

EXERCISES
1. Identify the last three items (consumer goods and durable goods)
you purchased. Alternatively, select any three items you
purchased during the last two months. Choose diverse items and
analyze each item in terms of the following factors:
a. Why did you buy that item? How did you decide what to get?
b. What attributes proved most important in narrowing your
choices? Create an attribute analysis chart for each item (see
Figure 8.4 "Sig’s Product-Attribute Scoring").
c. Where did you get your information about the item?
d. Where did you go to buy the item?
e. In what kind of market did you make your purchase?
f. Where did the money come from for your purchase?
g. How much did you pay for the item, and how did you pay for
it?
h. How would you rate your satisfaction with your purchase?
i. If or when you purchase that type of item again, what might
you do differently?
2. In My Notes or your personal finance journal, record your favorite
strategies for making purchases. Include a specific recent example of
how you used each strategy. Your strategies may relate to bargain
shopping, high-end shopping, warranties, store brands, coupons,
discounts, rebates, seasonal shopping, expiry shopping, bulk buying,
cooperative buying, special sales, or other practices. Share your
consumer success stories with classmates and add at least one new idea
to your list.
3. Have you ever been the victim of a consumer scam? What scams have
you been exposed to that you managed to avoid? Describe your
experiences in My Notes or your personal finance journal. Find out how
many complaints of fraud the Federal Trade Commission received from
consumers in its most recent reporting year (e.g., see
http://www.ftc.gov/opa/2008/02/fraud.shtm). What were the most
common fraud complaints?
4. How informed are you about your rights as a consumer in your

state and as a citizen of the United States? For example, what are
your rights in returning unwanted purchases and recalled items?
In moving your house? In buying food? In having access to
electricity? Research a topic relevant to your personal situation

from the comprehensive list at the Federal Trade Commission’s

Consumer Guides and Protections for Citizens:
http://www.usa.gov/Citizen/Topics/Consumer_Safety.shtml.
How will what you learn guide you in your next related purchase
or in taking some other action? Visit the following Web sites to
learn more about the information and protections available to
you as a consumer. What services do the organizations and
agencies provide? What should you do if you have a complaint as
a consumer or suspect you are being scammed?
a. Better Business Bureau (http://www.bbb.org)

b. Federal Trade Commission (http://www.ftc.gov)
c. Consumer protection laws about making purchases
(http://www.ftc.gov/bcp/menus/consumer/shop.shtm)

8.2 A Major Purchase: Buying a Car
LEARNING OBJECTIVES
1. Show how the purchasing process (e.g., identifying the product, the
market, and the financing) may be applied to a car purchase.
2. Explain the advantages (and disadvantages) of leasing versus borrowing
as a form of financing.
3. Analyze all the costs associated with car ownership.
4. Define “lemon laws.”
Many adults will buy a car several times during their lifetimes. A car is a major
purchase. Its price can be as much as or more than one year’s disposable income. Its
annual operating costs can be substantial, including the cost of fuel, legally
mandated insurance premiums, and registration fees, as well as maintenance and
perhaps repairs and storage (parking). A car is not only a significant purchase, but
also an ongoing commitment.
In the United States, people spend a considerable

amount of time in their cars, commuting to work, Figure 8.8
driving their children to school and various activities,
driving to entertainment and recreational activities,
and so on. Most people want their car to provide not
only transportation, but also comforts and
conveniences. You can apply the purchasing model,
described in this chapter, to the car purchase.
First, you identify the need: What is your goal in owning © 2010 Jupiterimages
Corporation
a car? What needs will it fulfill? Here are some further
questions to consider:
• What kind of driving will you use the car

for? Will you depend on it to get you to work, or will you use it
primarily for weekend getaways?
• Do you need carrying capacity (for passengers or “stuff”) or hauling
capacity?
• Do you live in a metropolitan area where you will be driving shorter
distances at lower speeds and often idling in traffic?
254
• Do you live in a more rural area where you will be driving longer
distances at faster speeds?
• Do you live in a climate where winter or a rainy season would make
traction and storage an issue?
• How much time will you spend in the car every day?
• How many miles will you drive each year?
• How long do you expect to keep the car?
• Do you expect to resell or trade in the car?
Your answers to these questions will help you identify the product you want.
Identify the Product
Answering these questions can help identify the attributes you value in a car, based
on how you will use it. Cars have many features to compare. The most critical (in no
particular order) are shown in Figure 8.9 "Automobile Attributes and Relevance".
Figure 8.9 Automobile Attributes and Relevance
8.2 A Major Purchase: Buying a Car 255

All these attributes affect price, and you may think of others. Product attribution
scoring can help you identify the models that most closely fit your goals.
Mary lives on a dirt road in a rural area; she drives about 18,000 miles per year,
commuting to her job as an accountant at the corporate headquarters of an auto
parts chain and taking her kids to school. She is also a pretty good car mechanic
and does basic maintenance herself.
John lives in the city; he walks or takes a bus to his job as a market researcher for an
ad agency, but keeps a car to visit his parents in the suburbs. He drives about 5,000
miles per year, often crawling in traffic. All John knows about a car is that the key
goes in the ignition and the fuel goes in the tank.
John and Mary would rate these attributes very differently, and their scoring of the
same models would have very different results.
Mary may value fuel efficiency more, as she drives more (and so purchases more
fuel). Driving often and with her children, she may rank size, safety, and
entertainment features higher than John would, who is in his car less frequently
and alone. Mary relies on the car to get to work, so reliability would be more
important for her than for John, who drives only for recreational visits. But Mary
also knows that she can maintain and repair some things herself, which makes that
less of a factor.
Car attributes are widely publicized by car dealers and manufacturers, who are
among the top advertisers globally year after year.Advertising Age, “Global
Marketers: Top 100,” December 8, 2007, http://adage.com/images/random/
datacenter/2008/globalmarketing2008.pdf (accessed April 1, 2009). You can visit
dealerships in your area or manufacturers’ Web sites. Using the Internet is a more
efficient way of narrowing your search. Specialized print and online magazines,
such as Car and Driver, Road and Track, and Edmunds.com, offer detailed discussions
of model attributes and their actual performance. Consumer Reports also offers
ratings and reviews and also provides data on frequency of repairs and annual
maintenance costs.
You want to be sure to consider not only the price of buying the car, but also the
costs of operating it. Fuel, maintenance, repair, insurance, property taxes, and
registration may all be affected by the car’s attributes, so you should consider
operating costs when choosing the product. For example, routine repairs and
maintenance are more expensive for some cars. A more fuel-efficient car can
significantly lower your fuel costs. A more valuable car will cost more to insure and

will mean higher property (or excise) taxes. Moreover, the costs of fuel,
maintenance, insurance, registration, and perhaps property tax on the car will be
ongoing expenses—you want to buy a car you can afford and afford to drive.
If you are buying a new car, you know its condition, and so you can predict annual
maintenance and repair costs and the car’s longevity by the history for that model.
Depending on how long you expect to own the car, you may also be concerned with
its predicted resale value.
Used cars are generally less expensive than new. A used car has fewer miles left in
it. Its condition is less certain: you may not know how it has been driven or its
repair and maintenance history. This makes it harder to predict annual
maintenance and repair costs. Typically, since it is already used when you buy it,
you expect little or no resale value. You can gain a significant price savings in the
used car market, and there are good used cars for sale. You may just have to look a
bit harder to find one.
The National Automobile Dealers Association (NADA) offers a checklist for used
vehicle inspection when buying a used car. The NADA also publishes guidebooks on
used car book values (see http://www.nadaguides.com). Items to inspect in your
exterior, interior, and engine checks are outlined in Figure 8.10 "Used Car Buyer’s
Checklist".
Figure 8.10 Used Car Buyer’s ChecklistNational Automobile Dealers Association, http://www.nadaguides.com
(accessed November 23, 2009).

The condition of exterior and interior features can indicate past accidents, repairs,
or lack of maintenance that may increase future operating expenses, or just driving
habits that have left a less attractive or less comfortable vehicle.
Services like Carfax (http://www.carfax.com) provide research on a vehicle’s

history based on its VIN (vehicle identification number), including any incidence of
accidents, flooding, frame damage, or airbag deployment, the number and type of
owners (was it a rental or commercial vehicle?), and the mileage. All these events
affect your expectations of the vehicle’s longevity, maintenance and repair costs,
resale value, and operating costs, which can help you calculate its value and
usefulness.
Unless you are an expert yourself, you should always have a trained mechanic
inspect a used vehicle before you buy it. With cars, as with any item, the better
informed you are, the better you can do as a consumer. Given the cost of a car and
its annual expense, there is enough at stake with this purchase to make you
cautious.
Identify the Market
New cars are sold through car dealerships. The dealer has a contract with the
manufacturer to sell its cars in the retail market. Dealers may also offer repair and
maintenance services as well as parts and accessories made especially for the
models it sells.
New car dealers may also resell cars that they get as trade-ins, especially of the
same models they sell new. Used car dealers typically buy cars through auctions of
corporate, rental, or government cars.
Individuals selling a used car can also do so through

networking—in an online auction such as eBay, a virtual Figure 8.11
bulletin board such as Craig’s List, or the bulletin board
in the local college snack bar. Dealers will have more
information about the market, especially about the
supply of cars and price levels for them.
Some people prefer a new car, with its more advanced

features and more certain quality, but a used car may be
a viable substitute for many purchasers. Many people
buy used cars while their incomes are lower, especially
in the earlier stages of their adult (working) life. As income rises and concern for

convenience, reliability, and safety increases with age

and family size, consumers may move into the new car © 2010 Jupiterimages
market. Corporation
While they are two very different markets, the markets

for new and used cars are related. Supply of and
demand for new cars affect price levels in the new car market, but also in the used
car market. For example, when new car prices are high, more buyers seek out used
cars and when low, used car buyers may turn to the new car market.
Demand for cars is affected by macroeconomic factors such as business cycles and
inflation. If there is a recession and a rise in unemployment, incomes drop. Demand
for new cars will fall. Many people will decide to keep driving their current vehicle
until things pick up, unwilling to purchase a long-term asset when they are
uncertain about their job and paycheck. That slowing of demand may lower car
prices, but will also lower the resale or trade-in value of the current vehicle. For
first-time car buyers, that may be a good time to buy.
If there is inflation, it will push up interest rates because the price of borrowing
money rises with other prices. Since many people borrow when purchasing a car,
that will make the borrowing, and so the purchase, more costly, which will
discourage demand.
When the economy is expanding, on the other hand, and inflation and interest rates
are low, demand for new cars rises, pushing up prices. In turn, prices are kept in
check by competition. As demand for new cars rises, demand for used cars may fall,
causing the supply of used cars to rise as more people trade in their cars to buy a
new one. They trade them in earlier in the car’s life, so the quality of the used cars
on the market rises. This may be a good time to buy a used car.
Identify the Financing: Loans and Leases
The cost of a car is significant. Car purchases usually require financing through a
loan or a lease. Each may require a down payment, which you would take out of
your savings. That creates an opportunity cost of losing the return you could have
earned on your savings. You also lose liquidity: you are taking cash, a liquid asset,
and trading it for a car, a not-so-liquid asset.
Your opportunity cost and the cost of decreasing your liquidity are costs of buying
the car. You can reduce those costs by borrowing more (and putting less money
down), but the more you borrow, the higher your costs of borrowing. If you trade in

a vehicle, dealers will often use the trade-in value as the down payment and will sell
the car to you with “no money down.”
Car loans are available from banks, credit unions, consumer finance companies, and
the manufacturers themselves. Be sure to shop around for the best deal, as rates,
maturity, and terms can vary. If you shop for the loan before shopping for the car,
then the loan negotiation is separate from the car purchase negotiation. Both may
be complex deals, and there are many trade-offs to be made. The more
separate—and simplified—each negotiation is, the more likely you will be happy
with the outcome.
Loans differ by interest rate or annual percentage rate (APR) and by the time to
maturity. Both will affect your monthly payments. A loan with a higher APR is
costing you more and, all things being equal, will have a higher monthly payment. A
loan with a longer maturity will reduce your monthly payment, but if the APR is
higher, it is actually costing you more. Loan maturities may range from one to five
years; the longer the loan, the more you risk ending up with a loan that’s worth
more than your car.
Rebecca buys a used Saturn for $6,000, with $1,000 cash down from savings and a
GMAC-financed loan at 7.2 APR, on which she pays $115 a month for forty-eight
months. She could have gotten a twenty-four-month loan, but wanted to have
smaller monthly payments. After only twenty-five months, she totals her car in a
chain collision but luckily escapes injury. Now she needs another car. The Saturn
has no trade-in value, her insurance benefit won’t be enough to cover the cost of
another car, and she still has to pay off her loan regardless. Rebecca is out of luck,
because her debt outlived her asset. If your debt outlives your asset, your ability to
get financing when you go to replace that vehicle will be limited, because you still
have the old debt to pay off and now are looking to add a new debt—and its
payments—to your budget. Rebecca will have to use more savings and may have to
pay more for a second loan, if she can get one, increasing her monthly payments or
extending her debt over a longer period of time.
An alternative to getting a car loan is leasing a car. Leases are a common way of
financing a car purchase. A lease6 is a long-term rental agreement with a buyout
option7 at maturity. Typically, at the end of the lease, usually three or four years,
6. A rental agreement used as a you can buy the car outright for a certain amount, or you can give it back (and buy
form of financing for or lease another car), which removes the risk of having an asset that outlives its
automobile purchases.
financing. Leases specify an annual mileage limit, that is, the number of miles that
7. A feature of a lease that offers you can drive the car in a year before incurring additional costs. Leases also specify
the option to buy the asset the monthly payment and requirements for routine maintenance that will preserve
financed by the lease at the
the car’s value.
end of the lease term.

So, lease or borrow? The price of the car should be the same regardless of how it is
financed—the car should be worth what it’s worth, no matter how it is paid for. The
cost of borrowing, in percentage terms, is the interest rate or APR of the loan. The
costs of leasing, in dollars, are the down payment, the lease payments, and the
buyout. Since the price of the car itself is the same in either case, the present value
of all the lease costs should be the same as the price of the car. You can use what
you know about the time value of money to calculate the discount rate that
produces that price; that is the equivalent annual cost of the lease, in percentage
terms.
For example, you want to buy a car with a price of $19,000. You can get a car loan
with an APR of 6.5 percent from your bank. You are offered a lease requiring a down
payment of $2,999, monthly payments of $359 for three years, and a final buyout of
$5,000. The APR of the lease is actually 5.93 percent, which would make it the
cheaper financing alternative.
In general, the longer you intend to keep the car, the less sense it makes to lease. If
you typically drive a car “into the ground,” until it costs more to repair than
replace it, then you are better off borrowing and spreading the costs of financing
over a longer period. On the other hand, if you intend to keep the car only for the
term of the lease and not to exercise the buyout option, then it is usually more cost
effective to lease. You also need to consider whether or not you are likely to stay
within the mileage limits of the lease, as the mileage penalties can add significantly
to your costs.
Some people will say that they like to borrow and then “own” in order to have an
asset that can store value or “build equity.” Given the unpredictable nature of the
used car market, however, a car is really not an asset that can be counted on to
store value. Thinking of a car as something that you will use up (although over
several years) rather than as an asset you can preserve or save will help you make
better financial decisions.

When you are buying a car, you want to minimize the

cost of both the car and the financing. If you are Figure 8.12
purchasing both the car and the financing from the
same dealer, you should be careful to discuss them
separately. Car dealers, who offer loans and leases as
well as cars, often combine the three discussions,
offering a break on the financing to make the car more
affordable, or offering a break on the car to make the
financing more affordable. To complicate matters
further, they may also offer a rebate on a certain model
or with a certain lease. The more clearly you can
separate which costs belongs to which—the car or the
financing—the more clearly you can understand and
minimize your costs.
Purchase and Postpurchase

Corporation
A car purchase requires significant prepurchase
activities. Once you have identified and compared
appropriate car attributes, a seller, and financing
options, all you have to do is drive away, right? Not
quite.
Car purchases are one instance where the buyer is expected to haggle over price.
The sticker price is the manufacturer’s suggested retail price (MSRP)8 for that
vehicle model with those features. Dealers negotiate many of the factors that
ultimately determine the value of the purchase: the optional features of the car, the
warranty terms, service discounts on routine maintenance, financing terms,
rebates, trade-in value for you old car, and so on.
As more of these factors are discussed at once, the negotiation becomes more and
more complex. You can help yourself by keeping the negotiations as simple as
possible: negotiate one thing at a time, settle on that, and then negotiate the next
factor. Keep track of what has been agreed to as you go along. When each factor has
been negotiated, you will have the package deal.
Your ability to get a satisfying deal rests on your abilities as a negotiator. For this
reason, many people who find that process distasteful or suspect that their skills
are lacking find the car purchasing process distasteful. Dealers know this, and some
will try to attract customers by being more transparent about their own costs and
about prices. Some even promise the “no-dicker sticker” sale with no haggling over
price at all.
8. The “sticker price” for an item.

As with any product in any market, the more information you have, the better you
can negotiate. The more thorough your prepurchase activities, the more satisfying
your purchase will be.
While you own the car, you will maximize the benefits enjoyed by operating the
vehicle safely and by keeping it in good condition. Routine maintenance (e.g.,
replacing fluids, rotating tires) can ensure the quality and longevity of your vehicle.
New cars come with owner’s manuals that detail a schedule of service requirements
and good driving practices for your vehicle. You will be required to keep the car
legally insured and registered with the state where you reside, and you must
maintain a valid license to drive.
New cars, and some used cars, are sold with a

warranty9, which is a promise about the quality of the Figure 8.13
product, made for a certain period of time. The terms
and covered repair costs may vary. You should
understand the terms of the warranty, especially if
something covered should need servicing, so that you
know what repairs you may be charged for. The
manufacturer, and sometimes the seller, issues the
warranty. If you have questions about the warranty
after purchasing, it may be best to contact the © 2010 Jupiterimages
manufacturer directly. Corporation
If you are dissatisfied with your purchase (and the fault

seems to be with the car), your first step should be a
conversation with your dealer. If the problem is not addressed, you can contact the
automobile company directly; its Web site will provide you with a customer service
contact. If the dealer and the manufacturer refuse to make good, you should contact
your state’s consumer affairs division in the attorney general’s office. In some
states, there are entire state agencies or departments devoted to auto purchases.
For his first car Ray bought a ten-year-old coupe with only 60,000 miles on it for a
price that seemed too good to be true. The seller said the good price was in
9. A manufacturer’s guarantee of exchange for getting payment in full in cash. The car broke down right away,
product performance for a
period of time. however, and within two weeks died of a cracked block. When Ray complained, the
seller claimed he didn’t know about the cracked block and pointed out that there
10. Federal and state laws was no warranty on the car, so Ray was out of luck. Fortunately, Ray had read that a
protecting consumers against
products that repeatedly fail to defective car, referred to as a “lemon,” is covered under laws that protect
meet standards of consumers who unknowingly purchase a car that proves to be defective. Lemon
performance. The federal laws10 regulate sales terms, purchase cancellation conditions, and warranty
Magnuson-Moss Warranty Act
requirements. These laws are enforced on both the federal and state level in the
was enacted in 1975.

United States. Other consumer protection laws apply specifically to motor vehicles
and vary by state. Ray learned that laws in his state include used cars as well as new
ones, and when he told the seller, he was able to get most of his cash back.
KEY TAKEAWAYS
• The purchase process may be applied to a car purchase.

• Attribute scoring may be helpful to identify the product.
• Common car financing is through a loan or a lease.
• A warranty guarantees minimal satisfaction with performance
attributes.
• Laws protect consumers who are dissatisfied with their car purchases or
unknowingly buy defective cars.

EXERCISES
1. Perform an attribute analysis for your next new or used car. Go online to
research cars with the attributes you have prioritized, and find where
you could buy what you want locally. Then research the dealership,
including a quick check at the Better Business Bureau Web site or your
local chamber of commerce to learn if there have been many consumer
complaints. After researching the product, the market, and the price,
visit a dealership, preferably with a classmate or partner, for the
experience of getting information and practicing your negotiation skills
(but without making any commitments, unless you really are in the
market for a car at this time).
2. How will you finance a car? Play with the Car Loan Calculator at
http://www.edmunds.com/apps/calc/CalculatorController. First
identify a sample of new or used cars you would like to own, and for
each choice calculate what your down payment, monthly loan payments,
and term of payment would be. How much would you need to buy a car
and where would that money come from? How much could you afford to
pay each month and for how long? How could you modify your budget
to accommodate car payments?
3. For a car you would like to drive, calculate and compare what it would
cost you to buy it and to lease it. Use the Lease versus Buy Calculator at
http://www.leaseguide.com/leasevsbuy.htm. What would be the
advantages of owning the car? What would be the advantages of leasing
it? For your lifestyle, needs, and uses of a vehicle, should you buy or
lease?
4. View a 2009 Money Talks video on “Buying Cars in a Credit Crunch” at
http://articles.moneycentral.msn.com/video/default-ap.aspx?cp-
documentid=f5dda393-7ab1-4e25-b446- 30e313aa3796%26tab=Money
%20Talks%20News. What sources of financing does the video identify for
times when national banks and finance companies are not forthcoming
with car loans because of downturns in the economy?
5. Check the lemon laws in your state at Lemon Law America’s Web site:
http://www.lemonlawamerica.com/. Click on your state on the map.
What conditions do your state lemon laws cover? Some states do not
cover used or leased cars under lemon laws. Under federal laws, if you
buy a used car “as is,” do you still retain rights under the lemon laws?
Under federal lemon laws, in what situations, when the seller does not
divulge the information, may you be able to get your money back on a
car?

Chapter 9
Buying a Home
Introduction
Be it ever so humble, the “biggest” purchase you ever make may be your home.
Unlike most other consumer purchases, a home is expected to be more than a living
space; it is also an asset that stores and increases value. The house has a dual
financial role as both a nest and a nest egg.
There are substantial annual operating expenses for

repairs and maintenance, insurance, and taxes. Figure 9.1
Maintenance preserves a home’s value, insurance
protects that value, and taxes for community services
both enhance and secure its value.
A home purchase is typically financed with debt that

creates a significant monthly expense, the mortgage
payment, in your budget. A mortgage is a long-term
debt that obligates your cash flows for a long time, © 2010 Jupiterimages
perhaps even reducing your choices of careers and your Corporation
mobility.
Your choice of home reflects personal factors in your

life. These factors include your personal tastes, your age and stage of life, your
family size and circumstances, your health, and your career choices. These factors
are reflected in your decision to own a home, as well as in the location, size, and use
of your home.
266
Chapter 9 Buying a Home
9.1 Identify the Product and the Market
LEARNING OBJECTIVES
1. Describe the different building structures for residential dwellings.

2. Describe the different ownership structures for residential dwellings.
3. Identify the factors used by lenders to evaluate borrowers for mortgage
credit.
4. Identify the components of the mortgage affordability calculation and
calculate estimated mortgage affordability.
5. Identify the components of a buyer’s inspection checklist.
6. Explain the potential effects of business cycles, unemployment, and
inflation on the housing market.
7. Analyze the effects of the demand for housing financing on the housing
market.
Renting a Home
If you have already decided on a goal of home ownership, you have already
compared the costs and benefits of the alternative, which is renting. Renting
requires relatively few initial legal or financial commitments. The renter signs a
lease that spells out the terms of the rental agreement: term, rent, terms of
payments and fees, restrictions such as pets or smoking, and charges for damages. A
renter is usually required to give the landlord a security deposit to cover the
landlord’s costs of repairs or cleaning, as necessary, when the tenant moves out. If
the deposit is not used, it is returned to the departing tenant (although without any
interest earned).
Some general advantages and disadvantages of renting and owning are shown in
Figure 9.2 "Renting versus Owning".
267
Figure 9.2 Renting versus Owning
The choice of whether to rent or to own follows the pattern of life stages. People
rent early in their adult lives because they typically have fewer financial resources
and put a higher value on mobility, usually to keep more career flexibility. Since
incomes are usually low, the tax advantages of ownership don’t have much benefit.
As family size grows, the quality of life for dependents typically takes precedence,
and a family looks for the added space and comfort of a home and its benefits as an
investment. This is the mid-adult stage of accumulating assets and building wealth.
As income rises, the tax benefit becomes more valuable, too.
Often, in retirement, with both incomes and family size smaller, older adults will
downsize to an apartment, shedding responsibilities and financial commitments.
Home ownership decisions vary: some people just never want the responsibilities of
ownership, while some just always want a place of their own.
Finding an apartment is much like finding a home in terms of assessing its

attributes, comparing choices, and making a choice. Landlords, property managers,
9.1 Identify the Product and the Market 268

and agents all rent properties and use various media to advertise an available space.
Since the rent for an apartment is a regular expense, financed from current income
(not long-term debt), you need to find only the apartment and not the financing,
which simplifies the process considerably.
Assessing Attributes
Once you decide to own your home, you must choose the home to own, considering
the different kinds of homes and of home ownership.
There are single- and multiple-unit dwellings, for

example. A multiple-unit dwelling1 can be used to Figure 9.3
create rental income or to house extended family
members, but this choice imposes the responsibilities of
being a landlord and also limits privacy.
There are previously owned, new, and custom-built

homes. Previously owned homes may require some
renovation to make them comfortably modern and
convenient. New and custom-built homes typically have © 2010 Jupiterimages
Corporation
more modern features and conveniences and require
less maintenance and repair expense. Custom-built
homes are built to the homeowners’ specifications.
Sales of existing single-family homes far outnumber sales of new and custom
homes. In the month of February 2009, for example, 4.72 million existing homes
were sold compared to 337,000 sales of new homes. The average price of a new
house in February 2009 in the United States was $251,000.National Association of
Home Builders, http://www.nahb.org/fileUpload_
details.aspx?contentTypeID=3&contentID=97096&subContentID=153510 (accessed
November 23, 2009).
1. A residential building including
more than one housing unit,
such as a duplex, triplex, or Mobile homes2 are large trailers fitted with utilities connections, which can be
apartment building.
installed on permanent sites and used as residences. A mobile home may also be
2. A manufactured home, usually situated in a trailer park or mobile home community where the owner rents a lot.
under 1,000 sq. ft. in size. Mobile homes are often referred to as manufactured homes, and other examples of
3. An ownership arrangement manufactured homes are prefabricated or modular homes, which are moved to a
where individual housing units foundation site by trailer and then assembled.
are owned by individual
owners, while common spaces
are owned by the In a condominium3, the homeowner owns a unit in a multiple-unit dwelling, but
condominium association of
the common areas of the building are owned and managed by the condominium
unit owners.

owners’ association. Condo owners pay a fee to cover the costs of overall building
maintenance and operating expenses for common areas.
Cooperative housing4 is a unit in a building or complex owned by a nonprofit

association or a corporation for the residents’ use. Residents do not own the units,
but rather own shares in the cooperative association, which entitles them to the
right to dwell in its housing units.
Personal factors such as your age, family size, health,

and career help you to answer some of the following key Figure 9.4
questions:
• How large should the house be? How many

bedrooms and bathrooms?
• Which rooms are most important: kitchen,
family room, or home office?
• Do you need parking or a garage?
• Do you need storage space?
• Do you need disability accommodation?
• Do you want outside space: a yard, patio, or
deck?
• How important is privacy?
• How important is energy efficiency and
other “green” features? © 2010 Jupiterimages
• How important are design features and Corporation
appearance?
• How important is location and
environmental factors?
• Proximity to work? Schools? Shopping?
Family and friends?
After ranking the importance of such attributes, you can use an attribute-scoring
matrix to score your choices. After understanding exactly what you are looking for
in a home, you should begin to think about how much house you can afford.
Assessing Affordability
4. An ownership arrangement Before looking for a house that offers what you want, you need to identify a price
where the right to inhabit range that you can afford. Most people use financing to purchase a home, so your
living space is claimed by the
purchase of shares in the
ability to access financing or get a loan will determine the price range of the house
cooperative ownership of a you can buy. Since your home and your financing are long-term commitments, you
multi-unit dwelling. need to be careful to try to include future changes in your thinking.

For example, Jill and Jack are both twenty-five years old, newly married, and
looking to buy their first home. Both work and earn good incomes. The real estate
market is strong, especially with mortgage rates relatively low. They buy a two-
bedroom condo in a new development as a starter home.
Fast-forward five years. Jill is expecting their second child; while the couple is
happy about the new baby, neither can imagine how they will all fit in their already
cramped space. They would love to sell the condo and purchase a larger home with
a yard for the kids, but the real estate market has slowed, mortgage rates have
risen, and a plant closing last year has driven up unemployment in their area. Jill
hasn’t worked outside the home since their first child was born two years ago—they
are just getting by on one salary and a new baby will increase their
expenses—making it even more difficult to think about financing a larger home.
A lender will look at your income, your current debts, and credit history to assess
your ability to assume a mortgage. As discussed in Chapter 7 "Financial
Management", your credit score is an important tool for the lender, who may also
request verification of employment and income from your employer.
Lenders do their own calculations of how much debt you can afford, based on a
reasonable percentage, usually about 33 percent, of your monthly gross income that
should go toward your monthly housing costs, or principal, interest, taxes, and
insurance (PITI)5. If you have other debts, your PITI plus your other debt
repayments should be no more than about 38 percent of your gross income. Those
percentages will be adjusted for income level, credit score, and amount of the down
payment.
Say the lender assumes that 38 percent of your monthly gross income (annual gross
income divided by twelve) should cover your PITI plus any other debt payments.
Subtracting your other debt payments and estimated cost of taxes and insurance
leaves you with a figure for affordable monthly mortgage payments. Dividing that
figure by the mortgage factor for your mortgage’s maturity and mortgage rate
shows the affordable mortgage overall. Knowing what percentage your mortgage
will be of the home’s purchase price, you can calculate the maximum purchase
price of the home that you can afford. That affordable home purchase price is based
on your gross income, other debts, taxes, insurance, mortgage rate, mortgage
maturity, and down payment.
5. Principal, interest, taxes, and
insurance are the costs of
home ownership. PITI is Figure 9.5 "Mortgage Affordability Calculation" shows an example of this
usually calculated on a
calculation for a thirty-year, 6.5 percent mortgage.
monthly basis in the process of
determining the affordability
of a mortgage.

Figure 9.5 Mortgage Affordability Calculation
These kinds of calculations give both you and your lender a much clearer idea of
what you can afford. You may want to sit down with a potential lender and have
this discussion before you do any serious house hunting, so that you have a price
range in mind before you shop. Mortgage affordability calculators are also available
online.
Searching for a Home
After understanding exactly what you are looking for in a home and what you can
afford, you can organize your efforts and begin your search.
Typically, buyers use a realtor6 and realty listings to identify homes for sale. A real
estate broker can add value to your search by providing information about the
house and property, the neighborhood and its schools, recreational and cultural
opportunities, and costs of living.
6. A salesperson for real estate,

usually hired by the seller to Remember, however, that the broker or its agent, while helping you gather
help price, advertise, and show information and assess your choices, is working for the sellers and will be
the property and negotiate the compensated by the seller when a sale is made. Consider paying for the services of a
actual sale.

buyer’s agent, a fee-based real estate broker who works for the buyer to identify
choices independently of the purchase. The real estate industry is regulated by
state and federal laws as well as by self-regulatory bodies, and real estate agents
must be licensed to operate.
Increasingly, sellers are marketing their homes directly to save the cost of using a
broker. A real estate broker typically takes a negotiable amount up to 6 percent of
the purchase price, from which it pays a commission to the real estate agent. “For
sale by owner” sites on the Internet can make the exchange of housing information
easier and more convenient for both buyers and sellers. For example, Web sites
such as Picketfencepreview.com serve home sellers and buyers directly. Keep in
mind, however, that sellers acting as their own brokers and agents are not licensed
or regulated and may not be knowledgeable about federal and state laws governing
real estate transactions, potentially increasing your risk.
After you narrow your search and choose a prospective home in your price range,
you have the home inspected to assess its condition and project the cost of any
repairs or renovations. Many states require a home inspection before signing a
purchase agreement or as a condition of the agreement. A standard home
inspection checklist, based on information from the National Association of
Certified Home Inspectors, is shown in Figure 9.6 "Standard Home Inspection
Checklist".
Figure 9.6 Standard Home Inspection Checklist
As with a car, it is best to hire a professional (a structural engineer, contractor, or

licensed home inspector) to do the home inspection. For example, see the American
Association of Home Inspectors at http://www.ashi.org/. A professional will be able
to spot not only potential problems but also evidence of past problems that may

have been fixed improperly or that may recur—for example, water in the basement
or leaks in the roof. If there are problems, you will need an estimate for the cost of
fixing them. If there are significant and immediate repair or renovation costs
projected by the home’s condition, you may try to reduce the purchase price of the
property by those costs. You don’t want any surprises after you buy the house,
especially costly ones.
You will also want to do a title search, as required by your lender, to verify that
there are no liens7 or claims outstanding against the property. For example, the
previous owners may have had a dispute with a contractor and never paid his bill,
and the contractor may have filed a lien or a claim against the property that must
be resolved before the property can change hands. There are several other kinds of
liens; for example, a tax lien is imposed to secure payment of overdue taxes.
A lawyer or a title search company can do the search, which involves checking the
municipal or town records where a lien would be filed. A title search will also reveal
if previous owners have deeded any rights—such as development rights or water
rights, for example, or grants of right-of-way across the property—that would
diminish its value.
Identifying the Market
Housing costs are determined by the price of the house and by the price of the debt
that finances the house. House prices are determined by forces of supply and
demand, which in turn are determined by macroeconomic circumstances.
When the economy is contracting and incomes are decreasing, and especially if
unemployment rises and incomes become uncertain, buyers are hesitant to add the
significant financial responsibility of new debt to their budgets. They tend to
continue with their present arrangements or may try to move into cheaper
housing, downsizing to a smaller house, an apartment, or condo to decrease
operating expenses. When the economy is expanding, on the other hand,
expectations of rising incomes may encourage buyers to be bolder with their
purchasing decisions.
A house represents not only a housing expense but also an investment that can
serve as a store of wealth. In theory, if a contraction creates a market with declining
asset values, investors will seek out alternative investments, abandoning that
market. In other words, if house prices decline, the house’s value as an investment
7. An interest in a property
will decline. Investors will seek other assets in which to store wealth to avoid the
granted to secure payment of opportunity cost of making an investment that does not generate returns.
debt.

Housing markets are local, however. If the local economy is dominated by one
industry or by one large employer, the housing market will be sensitive to the fate
of that industry or employer. If a location has value independent of the local
economy, such as value as a vacation or retirement location, that value can offset
local concerns. In that case, housing prices may be less sensitive to the local
economy.
Since a house is an investment, the home buyer is concerned about its expected
future value. Future value is not easy to predict, however, as housing markets have
some volatility. In extreme periods, for example between 2004 and 2009, there was
extreme volatility (read more on the real estate bubble in Chapter 13 "Behavioral
Finance and Market Behavior"). Thus, depending on how long you intend to own
the home, it may or may not be realistic to try to predict price trends based on
macroeconomic cycles or factors. Some areas may seem to be always desirable, such
as Manhattan’s East Side or Malibu, California, but a severe economic shock or
boom can affect prices in those areas as well.
Figure 9.7 "U.S. Housing Prices 1890–2005 (Inflation-Adjusted Dollars)" shows

housing prices in the United States from 1890 to 2005 in inflation-adjusted dollars.
Figure 9.7 U.S. Housing Prices 1890–2005 (Inflation-Adjusted Dollars)
The data in Figure 9.7 "U.S. Housing Prices 1890–2005 (Inflation-Adjusted Dollars)"
display some remarkable stability to housing prices. For example, for the half-
century from the end of World War II until the mid-1990s, housing prices were
fairly flat, as they were in the period from around 1920 to 1940. This suggests that

while a house may be used to store value, it may not generate a real increase in
wealth. It seems that over the long term, housing prices are not highly sensitive to
economic cycles, population growth, building costs, or even interest rates.
Since the early 2000s, however, housing prices have soared. Most economists
attribute this to a sustained period of low unemployment rates, low mortgage rates,
and economic growth. As bubbles do, this one eventually burst in 2007 as the
economy slumped into a recession. Housing demand and prices fell, even with low
mortgage rates, creating a real buyer’s market. Many economists attribute the
severity of the slump to the banking crisis that froze the credit markets, because
most housing purchases are financed with debt.
Ability to buy a house rests on the ability to finance the purchase, to provide a
down payment, and to borrow. That ability is determined by the buyer’s personal
situation (e.g., stability of employment or income, credit history) and by
macroeconomic events such as interest rate levels, expected inflation, and liquidity
in the credit markets. If interest rates and inflation are low and there is liquidity in
the credit markets, it will be easier for buyers to borrow than if inflation and
interest rates are high and the credit market is illiquid. Demand for housing thus
relies on the availability of credit for the housing market.

KEY TAKEAWAYS
• Different building structures are
◦ single-unit or multiple-unit dwellings or mobile homes;

◦ previously owned, new, or custom built.
• Different ownership structures include
◦ conventional ownership,
◦ condominium,
◦ cooperative housing.
• The buyer’s inspection checklist includes
◦ structural elements;
◦ exterior elements;
◦ systems for plumbing, electrical, heating/cooling;
◦ outdoor buildings and features.
• Lenders assess income, current debts, and credit history to determine
the creditworthiness of borrowers.
• A mortgage affordability estimate uses an estimate of PITI and other
debt payments as a percentage of gross monthly income and of the
down payment as a percentage of the purchase price.
• Housing prices may be affected by business cycles as they affect
◦ unemployment and income levels;

◦ inflation, which affects not only the cost of houses but also
interest rates and the cost of home financing.
• Housing prices are affected by the availability of home financing,

which in turn depends on
◦ interest rates and inflation,

◦ liquidity in the credit markets.

EXERCISES
1. Perform an attribute analysis of your projected wants and needs

as a homeowner. Begin by prioritizing the following personal and
microeconomic factors in terms of their importance to you in
deciding when to buy a home.
◦ How large should the house be? How many bedrooms and
bathrooms?
◦ Which rooms are most important: kitchen, family room, or
home office?
◦ Do you need parking or a garage?
◦ Do you need storage space?
◦ Do you need disability accommodation?
◦ Do you want outside space: a yard, patio, deck?
◦ How important is privacy?
◦ How important is energy efficiency or other “green”
features?
◦ How important are design features and appearance?
◦ How important is location and environmental factors?
◦ Proximity to work? Schools? Shopping? Family and friends?
2. In your journal or My Notes describe hypothetically your first or next
home that you think you would like to own, including its location and
environment. Predict how much you think it might cost to own such a
home in your state. Then look through realty news and ads to find the
asking prices for homes or housing units similar to the one you
described. How accurate is your prediction?
3. Are you are a renter and likely to remain one for a few years? Read the
advice about renting housing at http://www.ehow.com/
how_111189_rent-apartment-house.html. How does that advice
compare with the information in this chapter about buying a house?
What advice, if any, would you add to the eHow.com site? Discuss with
classmates the ins and outs of being a tenant and the ins and outs of
being a landlord. Develop a comparison chart of benefits, drawbacks,
and risks.
4. Do you live in a dorm or at home with parents or other relatives? What
needs to happen for you to have a place of your own? Research Web sites
that aid students in finding independent housing, such as
http://collegelife.about.com/od/livingoffcampus/ht/Apartments.htm
and http://www.gooffcampus.com/. Develop a flexible plan and

timetable for finding and financing a place of your own and record it in
your personal finance journal.
5. Investigate the real estate market in your area. How do local housing
availability and pricing differ from other cities and towns, counties, and
states? Use online resources to find this information, such as
HousingPredictor.com, which provides independent real estate market
forecasts for local housing markets for all fifty U.S. states, or
RealtyTimes.com, an industry news source that likewise analyzes local
real estate markets nationwide. How stable or volatile is your real estate
market? Is it a buyer’s market or a seller’s market, and what does that
mean? To what local factors do you attribute the differences you find?
Share your findings with classmates.
6. Identify and analyze the macroeconomic factors that are affecting your
local real estate market. In what ways or to what extent does your local
economy reflect macroeconomic factors in the national economy?
According to the National Association of Realtors
(http://www.realtor.org/research), what are the most important
present trends in the real estate market? If you were shopping for a new
or existing home today, or were planning to build, how would each
macroeconomic factor and each trend you identify likely affect your
choices? Record your answers in My Notes or your personal finance
journal.
7. View the 2009 CBS News Money Matters video “Tips for First-Time Home
Buyers” at http://www.cbsnews.com/video/watch/?id=2947766n. What
do the commentators mean when they describe the current housing
market as a buyer’s market? What are four tips for avoiding overpaying
for a home? Now view Bloomberg’s Your Money video on “Buying a
Home” at http://www.youtube.com/watch?v=XnvirEoxRaQ. According
to the experts in this video, what are the first two steps in buying a
home? Other videos in the Bloomberg series cover related topics, such as
renting versus buying, tips on financing, and so on.

9.2 Identify the Financing
LEARNING OBJECTIVES
1. Define the effects of the down payment on other housing costs.

2. Calculate the monthly mortgage payment, given its interest rate,
maturity, and principal balance.
3. Distinguish between a fixed-rate and an adjustable-rate mortgage and
explain their effects on the monthly payment and interest rate.
4. Distinguish between a rate cap and a payment cap, and explain their
uses and risks.
5. Determine the effect of points on the monthly mortgage payment.
6. Identify potential closing costs.
Just as your house may be your most significant purchase, your mortgage may be
your most significant debt. The principal may be many times one year’s disposable
income and may need to be paid over fifteen or thirty years. The house secures the
loan, so if you default or miss payments, the lender may foreclose8 on your house
or claim ownership of the property, evict you, and resell the house to recover what
you owed. You may lose not only your house but also your home.
Banks, credit unions, finance companies, and mortgage

finance companies sell mortgages. They profit by Figure 9.8
lending and competing for borrowers. It makes sense to
shop around for a mortgage, as rates and terms (i.e., the
borrowers’ costs and conditions) may vary widely. The
Internet has made it easy to compare; a quick search for
“mortgage rates” yields many Web sites that provide
national and state averages, lenders in your area,
comparable rates and terms, and free mortgage
calculators. © 2010 Jupiterimages
Corporation
You may feel more comfortable getting your mortgage

through your local bank, which may process the loan
and then sell the mortgage to a larger financial
8. The repossession of real
institution. The local bank usually continues to service the loan, to collect the
property by a lender after a
default on the mortgage by the payments, but those cash flows are passed through to the financial institution
borrower, assuming the real (usually a much larger bank) that has bought the mortgage. This secondary
property has acted as collateral mortgage market allows your local bank to have more liquidity and less risk, as it
for the financing.
280
gets repaid right away, allowing it to make more loans. As long as you continue to
make your payments, your only interaction is with the bank that is servicing the
loan. Alternatively, local banks may earmark a percentage of mortgages to keep “in
house” rather than sell.
The U.S. government assists some groups to obtain home loans, such as Native
Americans, Americans with disabilities, and veterans. See, for example,
http://www.homeloans.va.gov/ondemand_ vets_stream_video.htm.
Keep in mind that the costs discussed in this chapter, associated with various kinds
of mortgages, may change. The real estate market, government housing policies,
and government regulation of the mortgage financing market may change at any
time. When it is time for you to shop for a mortgage, therefore, be sure you are
informed of current developments.
Down Payment
Mortgages require a down payment9, or a percentage of the purchase price paid in

cash upon purchase. Most buyers use cash from savings, the proceeds of a house
they are selling, or a family gift.
The size of the down payment does not affect the price of the house, but it can
affect the cost of the financing. For a certain house price, the larger the down
payment, the smaller the mortgage and, all things being equal, the lower the
monthly payments. An example of a thirty-year mortgage is shown in Figure 9.9
"Down Payment and Monthly Payment".
Figure 9.9 Down Payment and Monthly Payment
9. The share of the purchase price

paid in cash at the time of
purchase; also called earnest
money.
9.2 Identify the Financing 281

Usually, if the down payment is less than 20 percent of the property’s sale price, the
borrower has to pay for private mortgage insurance10, which insures the lender
against the costs of default. A larger down payment eliminates this expense for the
borrower.
The down payment can offset the annual cost of the financing, but it creates
opportunity cost and decreases your liquidity as you take money out of savings.
Cash will also be needed for the closing costs11 or transaction costs of this purchase
or for any immediate renovations or repairs. Those needs will have to be weighed
against your available cash to determine the amount of your down payment.
Monthly Payment
The monthly payment is the ongoing cash flow obligation of the loan. If you don’t
pay this payment, you are in default on the loan and may eventually lose the house
with no compensation for the money you have already put into it. Your ability to
make the monthly payment determines your ability to keep the house.
The interest rate and the maturity (lifetime of the mortgage) determine the
monthly payment amount. With a fixed-rate mortgage12, the interest rate remains
the same over the entire maturity of the mortgage, and so does the monthly
payment. Conventional mortgages are fixed-rate mortgages for thirty, twenty, or
fifteen years.
The longer the maturity, the greater the interest rate, because the lender faces
more risk the longer it takes for the loan to be repaid.
10. Insurance that insures the
lender against any losses
incurred by the costs of a loan A fixed-rate mortgage is structured as an annuity: regular periodic payments of
default. equal amounts. Some of the payment is repayment of the principal and some is for
the interest expense. As you make a payment, your balance gets smaller, and so the
11. Transaction costs of the home
purchase, including appraisal interest portion of your next payment is smaller, and the principal payment is
fees, title, fee, and title larger. In other words, as you continue making payments, you are paying off the
insurance; closing costs are balance of the loan faster and faster and paying less and less interest.
paid at the closing or purchase
of the home.
12. A mortgage loan with a fixed An example of a mortgage amortization13, or a schedule of interest and principal
interest rate over the life of the payments over the life of the loan, is shown in Figure 9.10 "A Mortgage
loan. Amortization: Year One of a Thirty-Year, Fixed-Rate 6.5 Percent Mortgage". The
13. A schedule of mortgage mortgage is a thirty-year, fixed-rate mortgage. Only year one is shown, but the
payments showing the spreadsheet extends to show the amortization over the term of the mortgage.
amounts of each payment that
pay interest and that pay
principal.

Figure 9.10 A Mortgage Amortization: Year One of a Thirty-Year, Fixed-Rate 6.5 Percent Mortgage
In the early years of the mortgage, your payments are mostly interest, while in the
last years they are mostly principal. It is important to distinguish between them
because the mortgage interest is tax deductible. That tax benefit is greater in the
earlier years of the mortgage, when the interest expense is larger.
Monthly mortgage payments can be estimated using the mortgage factor14. The
mortgage factor is a calculation of the payment per $1,000 of the mortgage loan,
given the interest rate and the maturity of the mortgage. Mortgage factors for
thirty-, twenty-, and fifteen-year mortgages are shown in Figure 9.11 "Mortgage
Factors for Various Mortgage Rates".
14. The mortgage payment per

$1,000 of principal.

Figure 9.11 Mortgage Factors for Various Mortgage Rates
The monthly payment can be calculated as
mortgage factor × principal ÷ 1,000.
So, if you were considering purchasing a house for $250,000 with a $50,000 down
payment and financing the remaining $200,000 with a thirty-year, 6.5 percent
mortgage, then your monthly mortgage payment would be 6.32 × $200,000 ÷ 1,000 =
$1,264. If you used a fifteen-year mortgage, your monthly payment would be 8.71 ×
$200,000 ÷ 1,000 = $1,742. If you got the thirty-year mortgage but at a rate of 6
percent, your monthly payment would be $1,200.
Potential lenders and many Web sites provide mortgage calculators to do these
calculations, so you can estimate your monthly payments for a fixed-rate mortgage
if you know the mortgage rate, the term to maturity, and the principal borrowed.

Mortgage Designs
So far, the discussion has focused on fixed-rate mortgages, that is, mortgages with
fixed or constant interest rates, and therefore payments, until maturity. With an
adjustable-rate mortgage (ARM)15, the interest rate—and the monthly
payment—can change. If interest rates rise, the monthly payment will increase, and
if they fall, it will decrease. By federal law, increases in ARM interest rates cannot
rise more than 2 percent at a time, but even with this rate cap16, homeowners with
ARMs are at risk of seeing their monthly payment increase. Borrowers can limit this
interest rate risk with a payment cap, which, however, introduces another risk.
A payment cap17 limits the amount by which the

payment can increase or decrease. That sounds like it Figure 9.12
would protect the borrower, but if the payment is
capped and the interest rate rises, more of the payment
pays for the interest expense and less for the principal
payment, so the balance is paid down more slowly. If
interest rates are high enough, the payment may be too
small to pay all the interest expense, and any interest
not paid will add to the principal balance of the
mortgage.
Corporation
In other words, instead of paying off the mortgage, your
payments may actually increase your debt, and you
could end up owing more money than you borrowed,
even though you make all your required payments on time. This is called negative
amortization. You should make sure you know if your ARM mortgage is this type of
loan. You can voluntarily increase your monthly payment amount to avoid the
negative effects of a payment cap.
Adjustable-rate mortgages are risky for borrowers. ARMs are usually offered at
15. A mortgage loan with a floating
or adjustable rate of interest. lower rates than fixed-rate mortgages, however, and may be more affordable.
Borrowers who expect an increase in their disposable incomes, which would offset
16. A limit on the potential the risk of a higher payment, or who expect a decrease in interest rates, may prefer
adjustment to the mortgage
interest rate. an adjustable-rate mortgage, which can have a maturity of up to forty years.
Otherwise, a fixed-rate mortgage is better.
17. A limit to the potential
adjustment to the mortgage
payment. There are mortgages that combine fixed and variable rates—for example, offering a
18. A mortgage that offers a fixed rate for a specified period of time, and then an adjustable rate. Another type
shorter maturity but with of mortgage is a balloon mortgage18 that offers fixed monthly payments for a
lower payments and a large specified period, usually three, five, or seven years, and then a final, large
principal balance due at
repayment of the principal. There are option ARMs, where you pay either interest
maturity.

only or principal only for the first few years of the loan, which makes it more
affordable. While you are paying interest only, however, you are not accumulating
equity in your investment.
As an asset, a house may be used to secure other types of loans. A home equity
loan19 or a second mortgage allows a homeowner to borrow against any equity in
the home. A home improvement loan is a type of home equity loan. A home equity
line of credit (HELOC)20 allows the homeowner to secure a line of credit, or a loan
that is borrowed and paid down as needed, with interest paid only on the
outstanding balance. A reverse mortgage21 is designed to provide homeowners
with high equity a monthly income in the form of a loan. A reverse mortgage
essentially is a loan against your home that you do not have to pay back for as long
as you live there. To be eligible for most reverse mortgages, you must own your
home and be sixty-two years of age or older. You or your estate repays the loan
when you sell the house or die.
Points
Points22 are another kind of financing cost. One point is one percent of the
mortgage. Points are paid to the lender as a form of prepaid interest when the
mortgage originates and are used to decrease the mortgage rate. In other words,
paying points is a way of buying a lower mortgage rate.
In deciding whether or not it is worth it to pay points, you need to think about the
difference that the lower mortgage rate will make to your monthly payment and
how long you will be paying this mortgage. How long will it take for the points to
pay for themselves in reduced monthly payments? For example, suppose you have
19. A loan secured by home equity
value.
the following choices for a thirty-year, fixed rate, $200,000 mortgage: a mortgage
rate of 6.5 percent with no points or a rate of 6 percent with 2 points.
20. A loan secured by home equity
value, structured such that
principal may be borrowed First, you can calculate the difference in your monthly payments for the two
only as needed, and interest
different situations. Using the mortgage factor for a thirty-year mortgage, the
paid only on the balance
outstanding. monthly payments in each case would be the mortgage factor × $200,000 ÷ 1,000 or
21. A loan secured by equity value,

most often used for elderly Points Mortgage rate Mortgage factor Monthly payment
homeowners to extract equity
value while retaining home 0 6.50% 6.32 1,264
ownership. Typically, the loan
balance is payable at the home 2 6.00% 6.00 1,200
owner’s death.
22. One percent of the mortgage Paying the two points buys you a lower monthly payment and saves you $64 dollars
value, used as prepaid interest per month. The two points cost $4,000 (2 percent of $200,000). At the rate of $64 per
paid at time of purchase.

month, it will take 62.5 months ($4,000 ÷ 64) or a little over five years for those
points to pay for themselves. If you do not plan on having this mortgage for that
long, then paying the points is not worth it. Paying points has liquidity and
opportunity costs up front that must be weighed against its benefit. Points are part
of the closing costs, but borrowers do not have to pay them if they are willing to
pay a higher interest rate instead.
Closing Costs
Other costs of a house purchase are transaction costs, that is, costs of making the
transaction happen that are not direct costs of either the home or the financing.
These are referred to as closing costs, as they are paid at the closing, the meeting
between buyer and seller where the ownership and loan documents are signed and
the property is actually transferred. The buyer pays these closing costs, including
the appraisal fee, title insurance, and filing fee for the deed.
The lender will have required an independent appraisal23 of the home’s value to
make sure that the amount of the mortgage is reasonable given the value of the
house that secures it. The lender will also require a title search24 and contract for
title insurance25. The title company will research any claims or liens on the deed;
the purchase cannot go forward if the deed may not be freely transferred. Over the
term of the mortgage, the title insurance protects against flaws not found in the
title and any claims that may result. The buyer also pays a fee to file the property
23. An opinion of the market value deed with the township, municipality, or county. Some states may also have a
of a property done by a property transfer tax26 that is the responsibility of the buyer.
professional appraiser who is
familiar with the real estate
market and with housing, and Closings may take place in the office of the title company handling the transaction
who has been certified to do
appraisals.
or at the registry of deeds. Closings also may take place in the lender’s offices, such
as a bank, or an attorney’s office and usually are mediated between the buyer and
24. A search of public records to the seller through their attorneys. Lawyers who specialize in real estate ensure that
determine if there are any
restrictions or allowances on
all legal requirements are met and all filings of legal documents are completed. For
the property to be purchase, or example, before signing, home buyers have a right to review a U.S. Housing and
any liens, or debts such as a Urban Development (HUD) Settlement Statement twenty-four hours prior to the
mortgage balance, overdue closing. This document, along with a truth-in-lending disclosure statement, sets out
taxes, a mechanic’s lien, and so
on, that must be paid if the and explains all the terms of the transaction, all the costs of buying the house, and
property is sold. all closing costs. Both the buyer and the seller must sign the HUD document and are
legally bound by it.
25. Insurance purchased by the
purchaser of the property that
insures against any omission
from the title search.
26. A tax on the transfer of title to

property; a transaction cost of
purchasing property.

KEY TAKEAWAYS
• The percentage of the purchase price paid upfront as the down payment
will determine the amount that is borrowed. That principal balance on
the mortgage, in turn, determines the monthly mortgage payment.
• A larger down payment may make the monthly payment smaller but
creates the opportunity cost of losing liquidity.
• A fixed-rate mortgage is structured as an annuity; the monthly
mortgage payment can be calculated from the mortgage rate, the
maturity, and the principal balance on the mortgage.
• A fixed-rate mortgage has a fixed mortgage rate and fixed monthly
payments.
• An adjustable-rate mortgage may have an adjustable mortgage rate and/
or adjustable payments.
• A rate cap or a payment cap may be used to offset the effects of an
adjustable-rate mortgage on monthly payments.
• Points are borrowing costs paid upfront (rather than over the maturity
of the mortgage).
• Closing costs are transaction costs such as an appraisal fee, title search
and title insurance, filing fees for legal documents, transfer taxes, and
sometimes realtors’ commissions.

EXERCISES
1. You are considering purchasing an existing single family house

for $200,000 with a 20 percent down payment and a thirty-year
fixed-rate mortgage at 5.5 percent.
a. What would be your monthly mortgage payment?

b. If you decided to buy two points for a rate of 5 percent, how
much would you save in monthly payments? Would it be
worth it to buy the points? Why, or why not?
c. When should you consider an adjustable-rate mortgage?
2. Review the explanation of adjustable-rate mortgages on the consumer
guide site of the U.S. Federal Reserve (the Fed) at
http://www.federalreserve.gov/pubs/arms/arms_english.htm.
According to the Fed, why should you be cautious about adjustable-rate
mortgages? Download the “Mortgage Shopping Worksheet” at this Web
site as a guide to comparing features of ARMs with lenders.
3. Do you presently rent or own your home or apartment? What are your
housing costs? What percent of your income is taken up in housing
costs? If your housing is costing you more than a third of your income,
what could you do to reduce that cost? Record your alternatives in your
personal finance journal.
4. As a prospective homeowner, what would be your estimated PITI?
Would a bank consider that you qualify for a mortgage loan at this time?
Why or why not? What criteria do lenders use to determine your
eligibility for a home mortgage?
5. Can you afford a mortgage now? How much of a mortgage could you
afford? Answer these questions using online mortgage affordability
calculators, found, for example, at http://cgi.money.cnn.com/tools/
houseafford/houseafford.html, http://www.bankrate.com/calculators/
mortgages/new-house-calculator.aspx, and
http://articles.moneycentral.msn.com/Banking/Loan/
HomeAffordabilityCalculator.aspx. If you cannot afford a mortgage now,
how would your personal situation and/or your budget need to change
to make that possible? Establish home affordability as a goal in your
financial planning. Write in My Notes or your personal finance journal
how and when you expect you will reach that goal.
6. Read about the closing process at http://mortgage.lovetoknow.com/
The_Closing_Process_When_Buying_a_House. According to Love to
Know, who attends the closing? What legal documents are processed at
the closing?

7. Re-review local real estate, condo, or apartment listings in the price

range you have now determined is truly affordable for you. For learning
purposes, choose a home you would like to own and clip the ad with
photo to put in your personal finance journal. Record the purchase
price, the down payment you would make, the mortgage amount you
would seek, the current interest rates on a mortgage loan for fixed- and
adjustable-rate mortgages for various periods or maturities, the type of
mortgage you would prefer, the rate and maturity you would seek, the
points you would buy (if any), the amount of monthly mortgage
payments you would expect to make, and the names of lenders you
would consider approaching first.

9.3 Purchasing and Owning Your Home
LEARNING OBJECTIVES
1. Identify the components of a purchase and sale agreement.

2. Explain the importance of a capital budget in determining capital
spending priorities.
3. Identify the financing events you may encounter during the maturity of
a mortgage.
4. Define the borrower’s and the lender’s responsibilities to the mortgage.
5. Explain the consequences of default and foreclosure.
The Purchase Process
Now that you’ve chosen your home and figured out the financing, all that’s left to
do is sign the papers, right?
Once you have found a house, you will make an offer to the seller, who will then
accept or reject your offer. If the offer is rejected, you may try to negotiate with the
seller or you may decide to forgo this purchase. If your offer is accepted, you and
the seller will sign a formal agreement called a purchase and sale agreement27,
specifying the terms of the sale. You will be required to pay a nonrefundable
deposit, or earnest money28, when the purchase and sale agreement is signed. That
money will be held in escrow29 or in a restricted account and then applied toward
the closing costs at settlement.
27. The legally binding agreement
that sets the terms of the
property transaction as agreed The purchase and sale agreement will include the following terms and conditions:
to by buyer and seller.
28. A nonrefundable deposit paid

by the buyer to the seller at the • A legal description of the property, including boundaries, with a site
time of the purchase and sale survey contingency
agreement then applied toward • The sale price and deposit amount
the closing costs.
• A mortgage contingency, stating that the sale is contingent on the final
29. A restricted account used for approval of your financing
the earnest money until • The closing date and location, mutually agreed upon by buyer and
closing.
seller
30. Any agreements regarding • Conveyances30 or any agreements made as part of the offer—for
property features also included example, an agreement as to whether the kitchen appliances are sold
in the transaction, such as
appliances, satellite dishes, and
with the house
so on.
291
• A home inspection contingency specifying the consequences of a home

inspection and any problems that it may find, if not already completed
and included in the price negotiation
• Possession date, usually the closing date
• A description of the property insurance policy that will cover the home
until the closing date
Property disclosures of any problems with the property that must be legally
disclosed, which vary by state, except that lead-paint disclosure is a federal
mandate for any housing built before 1978.
After the purchase and sale agreement is signed, any conditions that it specified
must be fulfilled before the closing date. If those conditions are the seller’s
responsibility, you will want to be sure that they have been fulfilled before closing.
Read all the documents before you sign them and get copies of everything you sign.
Do not hesitate to ask questions. You will live with your mortgage, and your house,
for a long time.
Capital Expenditures
A house and property need care; even a new home will have repair and
maintenance costs. These costs are now a part of your living expenses or operating
budget.
If you have purchased a home that requires renovation or repair, you will decide
how much of the work you can do immediately and how much can be done on an
annual basis. A capital budget is helpful to project these capital expenditures and
plan the income or savings to finance them. You can prioritize these costs by their
urgency and by how they will be done.
For example, Sally and Chris just closed on an older

home and are planning renovations. During the home Figure 9.13
inspection, they learned that the old stone foundation
would need some work. They would like to install more
energy-efficient windows and paint the walls and strip
and refinish the old, wood floors.
Their first priority should be the foundation on which

the house rests. The windows should be the next on the
list, as they will not only provide comfort but also
reduce the heating and cooling expenses. Cosmetic
9.3 Purchasing and Owning Your Home 292

repairs such as painting and refinishing can be done

later. The walls should be done first (in case any paint © 2010 Jupiterimages
drips on the floors) and then the floors. Corporation
Renovations should increase the resale value of your

home. It is tempting to customize renovations to suit
your tastes and needs, but too much customization will make it more difficult to
realize the value of those renovations when it comes time to sell. You will have a
better chance of selling at a higher price if there is more demand for it, if it appeals
to as many potential buyers as possible. The more customized or “quirky” it is, the
less broad its appeal may be.
Early Payment
Two financing decisions may come up during the life of a mortgage: early
payment31 and refinancing32. Some mortgages have an early payment penalty33
that fines the borrower for repaying the loan before it is due, but most do not. If
your mortgage does not, you may be able to pay it off early (before maturity) either
with a lump sum or by paying more than your required monthly payment and
having the excess payment applied to your principal balance.
If you are thinking of paying off your mortgage with a lump sum, then you are
weighing the value of your liquidity, the opportunity cost of giving up cash, against
the cost of the remaining interest payments. The cost of giving up your cash is the
loss of any investment return you may otherwise have from it. You would compare
that to the cost of your mortgage, or your mortgage rate, less the tax benefit that it
provides.
For example, suppose you can invest cash in a money market mutual fund (MMMF)
that earns 7 percent. Your mortgage rate is 6 percent, and your tax rate is 25
percent. Your mortgage costs you 6 percent per year but saves you 25 percent of
that in taxes, so your mortgage really only costs you 4.5 percent, or 75 percent of 6
percent. After taxes, your MMMF earns 5.25 percent, or 75 percent of 7 percent.
31. Redemption or paying back the Since your cash is worth more to you as a money market investment where it nets
mortgage loan before its 5.25 percent than it costs you in mortgage interest (4.5 percent), you should leave it
maturity.
in the mutual fund and pay your mortgage incrementally as planned.
32. Attaining a new mortgage and
simultaneously paying off the
old mortgage. On the other hand, if your money market mutual fund earns 5 percent, but your
mortgage rate is 8 percent and you are in the 25 percent tax bracket, then the real
33. A cash penalty for the
borrower for an early payment;
cost of your mortgage is 6 percent, which is more than your cash can earn. You
this clause is not included in all would be better off using the cash to pay off your mortgage and eliminating that 6
mortgages. percent interest cost.

You also need to weigh the use of your cash to pay off the mortgage versus other
uses of that cash. For example, suppose you have some money saved. It is earning
less than your after-tax mortgage interest, so you are thinking of paying down the
mortgage. However, you also know that you will need a new car in two years. If you
use that money to pay down the mortgage now, you won’t have it to pay for the car
two years from now. You could get a car loan to buy the car, but the interest rate on
that loan will be higher than the rate on your mortgage, and the interest on the car
loan is not tax deductible. If paying off your mortgage debt forces you to use more
expensive debt, then it is not worth it.
One way to pay down a mortgage early without sacrificing too much liquidity is by
making a larger monthly payment. The excess over the required amount will be
applied to your principal balance, which then decreases faster. Since you pay
interest on the principal balance, reducing it more quickly would save you some
interest expense. If you have had an increase in income, you may be able to do this
fairly “painlessly,” but then again, there may be a better use for your increased
income.
Over a mortgage as long as thirty years, that interest expense can be

substantial—more than the original balance on the mortgage. However, that choice
must be made in the context of the value of your alternatives.
Refinancing
You may think about refinancing your mortgage if better mortgage rates are
available. Refinancing means borrowing a new debt or getting a new mortgage and
repaying the old one. It involves closing costs: the lender will want an updated
appraisal, a title search, and title insurance. It is valuable to refinance if the
mortgage rate will be so much lower that your monthly payment will be
substantially reduced. That in turn depends on the size of your mortgage balance.
If interest rates are low enough and your home has

appreciated so that your equity has increased, you may Figure 9.14
be able to refinance and increase the principal balance
on the new mortgage without increasing the monthly
payment over your old monthly payment. If you do that,
you are withdrawing equity from your house, but you
are not allowing it to perform as an investment, that is
to store your wealth.
If you would rather take gains from the house and

invest them differently, that may be a good choice. But

if you want to take gains from the house and use those
for consumption, then you are reducing the investment © 2010 Jupiterimages
returns on your home. You are also using nonrecurring Corporation
income to finance recurring expenses, which is not
sustainable. There is also a danger that property value
will decrease and you will be left with a mortgage worth
more than your home.
Default, Foreclosure, and Fraud
If you have a change of circumstances—for example, you lose your job in an

economic downturn, or you have unexpected health care costs in your family—you
may find that you are unable to meet your mortgage obligations as planned: to
make the payments. A mortgage is secured by the property it financed. If you miss
payments and default on your mortgage, the lender has recourse to foreclose on
your property, to evict you and take possession of your home, and then to sell it or
lease it to recover its investment. Under normal circumstances, lenders incur a cost
in repossessing a home, and usually lose money in its resale. It may be possible to
renegotiate terms of your mortgage to forestall foreclosure. You may want to
consult with a legal representative, or to contact federal and/or state agencies for
assistance.
You may believe you are having trouble meeting your mortgage obligations because
they are not what you thought they would be. Lenders profit by lending. When you
are borrowing, it is important to understand the terms of your loan. If those terms
will adjust under certain conditions, you must understand what could happen to
your payments and to the value of your home. It is your responsibility to
understand these conditions. However, the lender has a responsibility to disclose
the lending arrangement and all its costs, according to federal and state laws
(which vary by state). If you believe that all conditions and terms of your mortgage
were not fairly disclosed, you should contact your state banking regulator or the
U.S Department of Housing and Urban Development (HUD). There are also
consumer advocacy groups that will help clarify the laws and explore any legal
recourse you may have.
Just as your lender has a legal obligation to be forthcoming and clear with you, you
have an obligation to be truthful. If you have misrepresented or omitted facts on
your mortgage application, you can be held liable for mortgage fraud. For example,
if you have overstated your income, misled the lender about your employment or
34. Intentional misrepresentation your intention to live in the house, or have understated your debts, you may be
or omission of facts
perpetrated by a borrower in prosecuted for mortgage fraud34. Other forms of mortgage fraud are more
the process of obtaining elaborate, such as inflating the appraisal amount in order to borrow more.
mortgage financing.

Mortgage fraud can be perpetrated by the borrower, appraiser, or loan officer who
originates the loan. Figure 9.15 "Mortgage Loan Fraud in the United States" shows
mortgage fraud in the United States through 2006—had the graph continued, you
would see even more fraud in 2007, just before the recent housing bubble burst.
Figure 9.15 Mortgage Loan Fraud in the United StatesFinancial Crimes Enforcement Network, “Mortgage Loan
Fraud: An Industry Assessment based upon Suspicious Activity Report Analysis,” November 2006,
http://www.fincen.gov/news_room/rp/reports/pdf/MortgageLoanFraud.pdf (accessed December 2, 2009).
During the recent housing bubble, mortgage fraud was aggravated by low interest
rates that encouraged more borrowing and lending, often when it was less than
prudent to do so.
KEY TAKEAWAYS
• The purchase and sale agreement details the conditions of the sale.
• Conditions of the purchase and sale agreement must be met before the
closing.
• A capital budget can help you prioritize and budget for capital
expenditures.
• Early payment is the trade-off of interest expense versus the
opportunity cost of losing liquidity.
• Refinancing is the trade-off between lower monthly payments and
closing costs.
• Both borrowers and lenders have a responsibility to understand the
terms of the mortgage.
• Buyers, sellers, lenders, and brokers must be alert to predatory lending,
real estate scams, and possible cases of mortgage fraud.
• Default may result in the lender foreclosing on the property and
evicting the former homeowner.

EXERCISES
1. Read about home purchase agreements at http://real-

estate.lawyers.com/Home-Purchase-Agreements.html, and view the
standard purchase and sale agreement form at
http://www.jaresources.com/std3.doc. For comparison, find a sample
purchase and sale agreement for your state.
2. According to this chapter, what information is included in a purchase
and sale agreement?
3. Use the mortgage refinancing calculator at Bankrate.com
(http://www.bankrate.com/calculators/mortgages/refinance-
calculator.aspx) to find out if you would save money by refinancing your
real or hypothetical mortgage at this time. What factors should you take
into consideration when deciding to refinance?
4. Sample consumer advocacy groups online at
http://homeownersconsumercenter.com/. What kinds of help can you
get through such organizations?
5. What constitutes mortgage fraud? Find out at
http://homebuying.about.com/od/financingadvice/qt/
120407_mrgfraud.htm. According to the IRS Web site
(http://www.irs.gov/newsroom/article/0,,id=118224,00.html), what are
three common forms of real estate fraud? Discuss with others taking this
course the common ways that homebuyers can become involved both
directly and indirectly in mortgage or real estate fraud.
6. Survey the Department of Housing and Urban Development Web site on
how to avoid foreclosure at http://portal.hud.gov/portal/page/portal/
HUD/topics/avoiding_foreclosure. Inferring from information on this
site, what are ten steps people should take to avoid foreclosure?

Chapter 10
Personal Risk Management: Insurance
Introduction
Life is full of risks. You can try to avoid them or reduce their likelihood and
consequences, but you cannot eliminate them. You can, however, pay someone to
share them. That is the idea behind insurance.
There are speculative risks1, that is, risks that offer a chance of loss or gain, such
as developing a “killer app” that may or may not sell or investing in a corporate
stock that may or may not provide good returns. Such risks can be avoided simply
by not participating. They are almost always uninsurable.
There are pure risks2 of accidental or unintentional events, such as a car accident
or an illness. Pure risks are insurable because their probabilities can be calculated
precisely enough for the risk to be quantified, which means it can be priced, bought,
and sold.
Risk shifting3 is the process of selling risk to someone who then assumes the risk
and its consequences. Why would someone buy your risk? Because in a large
enough market, your risk can be diversified, which minimizes its cost.
Insurance can be purchased for your property and your

home, your health, your employment, and your life. In Figure 10.1
each case, you weigh the cost of the consequence of a
risk that may never actually happen against the cost of
insuring against it. Deciding what and how to insure is
really a process of deciding what the costs of loss would
be and how willing you are to pay to get rid of those
risks.
1. Intended risk that offers a
chance of loss or gain.
2. The risk of accidental or The costs of insurance can also be lowered through risk © 2010 Jupiterimages
Corporation
unintentional events avoidance or reduction strategies. For example,
3. Selling risk to avoid bearing
installing an alarm system in your home may reduce
the full consequence of homeowners’ insurance premiums because that reduces
unintentional events. the risk of theft. Of course, installing an alarm system
298
Chapter 10 Personal Risk Management: Insurance
has a cost too. Risk management is the strategic trade-off of the costs of reducing,
assuming, and shifting risks.
299
10.1 Insuring Your Property
LEARNING OBJECTIVES
1. Describe the purpose of property insurance.

2. Identify the causes of property damage.
3. Compare the kinds of homeowner’s insurance coverage and benefits.
4. Analyze the costs of homeowner’s insurance.
5. Compare the kinds of auto insurance to cover bodily injury and property
damage.
6. Explain the factors that determine auto insurance costs.
7. Analyze the factors used in determining the risks of the driver, the car,
and the driving region.
Property insurance is ownership insurance: it insures that the rights of ownership

conferred upon you when you purchased your property will remain intact.
Typically, property insurance covers loss of use from either damage or theft; loss of
value, or the cost of replacement; and liability for any use of the property that
causes damage to others or others’ property. For most people, insurable property
risks are covered by insuring two kinds of property: car and home.
Loss of use and value can occur from hazards such as

fire or weather disasters and from deliberate Figure 10.2
destruction such as vandalism or theft. When
replacement or repair is needed to restore usefulness
and value, that cost is the cost of your risk. For example,
if your laptop’s hard drive crashes, you not only have
the cost of replacing or repairing it, but also the cost of
being without your laptop for however long that takes.
Insuring your laptop shares that risk (and those costs)
with the insurer. © 2010 Jupiterimages
Corporation
Liability is the risk that your use of your property will

injure someone or something else. Ownership implies
control of, and therefore responsibility for, property
use.
For example, you are liable for your dog’s attack on a pedestrian and for your fallen
tree’s damage to a neighbor’s fence. You also are liable for damage a friend causes
300
while driving your car with your permission and for injury to your invited guests
who trip over your lawn ornament, fall off your deck, or leave your party drunk.
Legal responsibility can be from
• negligence4, or the failure to take usual precautions;

• strict liability5, or responsibility for intentional or unintentional
events;
• vicarious liability6, or responsibility for someone else’s use of your
possessions or someone else’s activity for which you are responsible.
Home Insurance Coverage
Homeowner’s insurance insures both the structure and the personal possessions
that make the house your home. Renter’s insurance protects your possessions even
if you are not the owner of your dwelling. You may not think you need insurance
until you are the homeowner, but even when you don’t need to insure against
possible damage or liability for your dwelling, you can still insure your possessions.
Even if your furniture came from your aunt’s house or a yard sale, it could cost a lot
to replace.
If you have especially valuable possessions such as jewelry or fine musical

instruments, you may want to insure them separately to get enough coverage for
them. Such items are typically referred to as listed property7 and are insured as
endorsements8 added on to a homeowners’ or renter’s policy. Items should be
appraised by a certified appraiser to determine their replacement or insured value.
A good precaution is to have an up-to-date inventory of your possessions such as

furniture, clothing, electronics, and appliances, along with photographs or video
4. Failure to take ordinary showing these items in your home. That inventory should be kept somewhere else,
precautions.
such as a safe deposit box. If the house suffered damage, you would then have the
5. Responsibility for intentional inventory to help you document your losses.
or unintentional events.
6. Responsibility for another’s use A homeowners’ policy covers damage to the structure itself as well as any
of your possessions, or for
outbuildings on the property and, in some cases, even the landscaping or
another’s actions, under
certain circumstances. infrastructure on the grounds, such as a driveway.
7. Valuable property insured

separately under a A homeowners’ policy does not cover
homeowner’s policy.
8. The clause of a homeowner’s

• animals;
policy insuring listed property.
10.1 Insuring Your Property 301

• property of renters, or property kept in an apartment regularly rented;

• business property, even if the business is conducted on the residential
premises.
According to information from the Insurances Services Office

(http://www.iso.com), an insurance industry data and research company, hazards
covered by the homeowner’s policy include
• fire or lightning;
• windstorm or hail;
• explosion;
• riot or civil commotion;
• damage caused by aircraft;
• damage caused by vehicles;
• smoke;
• vandalism or malicious mischief;
• theft;
• volcanic eruption;
• falling objects;
• weight of ice, snow, or sleet;
• accidental discharge or overflow of water or steam from within a
plumbing, heating, air conditioning, or automatic fire-protective
sprinkler system, or from a household appliance;
• sudden and accidental tearing apart, cracking, burning, or bulging of a
steam or hot water heating, air conditioning, or automatic fire-
protective system;
• freezing of a plumbing, heating, air conditioning, or automatic fire-
protective sprinkler system, or of a household appliance;
• sudden and accidental damage from artificially generated electrical
current (does not include loss to a tube, transistor, or similar
electronic component).
Note that floods and earthquakes are not covered. A homeowner in a flood- or
earthquake-prone area may buy special coverage, either from a private insurer or
from a federal or state program.
Homeowners’ insurance covers the less direct costs of hazards as well. For example,
the costs of removing damaged goods or temporary repairs are covered. The cost of
temporary housing and extra living expenses while repairs are made is covered,
although usually for a limited time or amount.

Homeowners’ policies cover liability for injuries on the property and for injuries
that the homeowner may accidentally inflict. You may also want to add an
umbrella policy9 that covers personal liabilities such as slander, libel, and
defamation of character. An umbrella policy may also extend over other assets,
such as vehicles or rentals covered by other insurance carriers. If you participate in
activities where you are assuming responsibilities for others—you are taking the
Cub Scout pack out for a hike, for example, or volunteering at your local recycling
center—you may want such extended liability coverage available through your
homeowners’ policy (also available separately).
Home Insurance Coverage: The Benefit
Home insurance policies automatically cover your possessions for up to 40 percent

of the house’s insured value. You can buy more coverage if you think they are
worth more. The benefits are specified as either actual cash value10 or
replacement cost11. Actual cash value tries to estimate the actual market value of
the item at the time of loss, so it accounts for the original cost less any depreciation
that has occurred. Replacement cost is the cost of replacing the item. For most
items, the actual cash value is less.
For example, say your policy insures items at actual

cash value. You are claiming the loss of a ten-year-old Figure 10.3
washer and dryer that were ruined when a pipe burst
and your basement flooded. Your coverage could mean
a benefit of $100 (based on the market price of ten-year-
old appliances). However, to replace your appliances
with comparable new ones could cost $1,000 or more.
The actual cash value is almost always less than the

replacement value, because prices generally rise over © 2010 Jupiterimages
Corporation
time and because items generally depreciate (rather
9. Personal liability insurance in
than appreciate) in value. A policy that specifies
attached to a homeowner’s
policy. benefits as replacement costs offers more actual
coverage. Guaranteed replacement costs12 are the full
10. Market value of insured
cost of replacing your items, while extended replacement costs13 are capped at
property at time of loss.
some percentage—for example, 125 percent of actual cash value.
11. Cost of replacing insured
property at time of loss.
Home Insurance Coverage: The Cost
12. The full cost of replacing
insured items at time of loss.
You buy home insurance by paying a premium to the insurance company. The
13. Insured amount capped at a insurance purchase is arranged through a broker, who may represent more than
specified percentage of actual
cash value.

one insurance company. The broker should be knowledgeable about various

policies, coverage, and premiums offered by different insurers.
The amount of the premium is determined by the insurer’s risk—the more risk, the
higher the premium. Risk is determined by
• the insured (the person buying the policy),

• the property insured,
• the amount of coverage.
To gauge the risk of the insured, the insurer needs information about your personal
circumstances and history, the nature of the property, and the amount of coverage
desired for protection. This information is summarized in Figure 10.4 "Factors that
Determine Insurance Premiums".
Figure 10.4 Factors that Determine Insurance Premiums
Insurers may offer discounts for enhancements that lower risks, such as alarm
systems or upgraded electrical systems. (Smoke detectors are required by law in
every state.) You also may be offered a discount for being a loyal customer, for
example, by insuring both your car and home with the same company. Be sure to
ask your insurance broker about available discounts for the following:
• Multiple policies (with the same insurer)

• Fire extinguishers
• Sprinkler systems

• Burglar and fire alarms

• Deadbolt locks and fire-safe window grates
• Longtime policyholder
• Upgrades to plumbing, heating, and electrical systems
The average premium for homeowners insurance in 2006 in the United States was
$804 a year, and for renters insurance was $189 a year. That year, Arizona
homeowners paid an average of $640 for insurance that cost $1,409 in
Texas.Insurance Information Institute, http://www.iii.org/media/facts/
statsbyissue/homeowners (accessed May 3, 2009). Premiums can vary, even for the
same levels of coverage for the same insured. You should compare policies offered
by different insurers to shop around for the best premium for the coverage you
want.
Insuring Your Car
If you own and drive a car, you must have car insurance. Your car accident may
affect not only you and your car, but also the health and property of others. A car
accident often involves a second party, and so legal and financial responsibility
must be assigned and covered by both parties. In the United States, financial
responsibility laws in each state mandate minimal car insurance, although what’s
“minimal” varies by state.
Conventionally, a victim or plaintiff in an accident is reimbursed by the driver at

fault or by his or her insurer. Fault has to be established, and the amount of the
claim agreed to. In practice, this has often been done only through extensive
litigation.
Some states in the United States and provinces in Canada have adopted some form
of no-fault insurance14, in which, regardless of fault, an injured’s own insurance
covers his or her damages and injuries, and a victim’s ability to sue the driver at
fault is limited. The idea is to lower the incidence of court cases and speed up
compensation for victims. The states with compulsory no-fault auto insurance, in
which personal injury protection (PIP) is required, include Florida, Hawaii, Kansas,
Kentucky, Massachusetts, Michigan, Minnesota, New Jersey, New York, North
Dakota, Pennsylvania, Utah, and Puerto Rico. Eleven other states use no-fault as
add-on or optional insurance.Insurance Information Institute, http://www.iii.org/
media/hottopics/insurance/nofault (accessed May 3, 2009). The remaining states in
14. A system of auto insurance
where the insured’s insurance the United States use the conventional tort system (suing for damages in court).
covers physical and property Understanding the laws of the state where you drive will help you to make better
damage and liability, insurance decisions.
regardless of “fault”
determined.

Auto Insurance Coverage
Auto insurance policies cover two types of consequences: bodily injury and
property damage. Each covers three types of financial losses. Figure 10.5
"Automobile Insurance Coverage" shows these different kinds of coverage.
Figure 10.5 Automobile Insurance Coverage
15. Responsibility for financial

losses from injuries sustained
in an accident for people
outside of the car of the driver
at fault.
16. Responsibility for financial Bodily injury liability15 refers to the financial losses of people in the other car that
losses from injuries sustained are injured in an accident you cause, including their medical expenses, loss of
in an accident for people inside
income, and your legal fees. Injuries to people in your car or to yourself are covered
of the car of the driver at fault.
by medical payments coverage16. Uninsured motorist protection17 covers your
17. Coverage of financial losses injuries if the accident is caused by someone with insufficient insurance or by an
from injuries sustained in an
unidentified driver.
accident if the driver at fault
has insufficient insurance.
18. Responsibility for damage to Property damage liability18 covers the costs to other people’s property from
property owned by people damage that you cause, while collision19 covers the costs of damage to your own
other than the driver at fault. property. Collision coverage is limited to the market value of the car at the time,
19. Responsibility for damage to usually defined by the National Automobile Dealers Association’s (NADA) Official
the property of the driver at Used Car Guide or “blue book” (http://www.nada.org). To reduce their risk, the
fault. lenders financing your car loan will require that you carry adequate collision

coverage. Comprehensive physical damage20 covers your losses from anything

other than a collision, such as theft, weather damage, acts of nature, or hitting an
animal.
Auto insurance coverage is limited, depending on the policy. The limits are typically
stated in numbers representing thousands of dollars. For example, 100/300/50
means that $100,000 is the limit on the payment to one person in an accident;
$300,000 is the limit on the amount paid in total (for all people) per accident; and
$50,000 is the limit on the amount of property damage liability that can be paid out.
Here’s an example of how it all works. Kit is driving home one night from a late
shift at the convenience store where he works. Sleepy, he drifts into the other lane
of the two-lane road and hits an oncoming car driven by Ray. Both Kit and Ray are
injured, and both cars are damaged. Figure 10.6 "Auto Insurance Coverage
Example" shows how Kit’s insurance will cover the costs.
Figure 10.6 Auto Insurance Coverage Example
Auto Insurance Costs
As with any insurance, the cost of having an insurer assume risk is related to the
cost of that risk. The cost of auto insurance is related to three factors that create
risk: the car, the driver, and the driving environment—the region or rating
territory.
The model, style, and age of the car determine how costly it may be to repair or
replace, and therefore the potential cost of damage or collision. The higher that
cost is, the higher the cost of insuring the car. For example, a 2009 luxury car will
20. Coverage for damage from
cost more to insure than a 2002 sedan. Also, different models have different safety
hazards. features that may lower the potential cost of injury to passengers, and those

features may lower the cost of insurance. Different models may come with different
security devices or be more or less attractive to thieves, affecting the risk of theft.
The driver is an obvious source of risk as the operator of the car. Insurers use
various demographic factors such as age, education level, marital status, gender,
and driving habits to determine which kinds of drivers present more risk. Not
surprisingly, young drivers (ages sixteen to twenty-four) of both sexes and elderly
drivers (over seventy) are the riskiest. Twice as many males as females die in auto
accidents, but more females suffer injuries. Nationally, in any year your chances of
being injured in a car accident are about one in a thousand.U.S. Census Bureau, The
Disaster Center, http://www.disastercenter.com/traffic (accessed May 3, 2009).
Your driving history and especially your accident claim history can affect your
premiums, as well as your criminal record and credit score. In some states, an
accident claim can double your cost of insurance over a number of years. Your
driving habits—whether or not you use the car to commute to work, for
example—can affect your costs as well. Some states offer credits or points that
reduce your premium if you have a safe driving record, are a member of the
American Automobile Association (AAA), or have passed a driver education course.
Where you live and drive also matters. Insurers use police statistics to determine
rates of traffic accidents, auto theft, and vandalism, for example. If you are in an
accident-prone area or higher crime region, you may be able to offset those costs by
installing safety and security features to your car.
Premium rates vary, so you should always shop around. You can shop through a
broker or directly. Online discount auto insurers have become increasingly popular
in recent years. Their rates may be lower, but the same cautions apply as for other
high-stakes transactions conducted online.
Also, premiums are not the only cost of auto insurance. You should also consider
the insurer’s reliability in addressing a claim. Chances are you rely on your car to
get to school, to work, or for your daily errands or recreational activities. Your car
is also a substantial investment, and you may still be paying off debt from financing
your car. Losing your car to repairs and perhaps being injured yourself is no small
inconvenience and can seriously disrupt your life. You want to be working with an
insurer who will cooperate in trying to get you and your car back on the road as
soon as possible. You can check your insurer’s reputation by the record of
complaints against it, filed with your state’s agency of banking and insurance, or
with your state’s attorney general’s office.

KEY TAKEAWAYS
• Property insurance is to insure the rights of ownership and to protect

against its liabilities.
• Property damage can be caused by hazards or by deliberate destruction,
such as vandalism or theft.
• Homeowner’s policies insure structures and possessions for actual cash
value or replacement cost; an umbrella policy covers personal liability.
• The cost of homeowner’s insurance is determined by the insured, the
property insured, and the extent of the coverage and benefits.
• Auto insurance coverage insures bodily injury through
◦ bodily injury liability,

◦ medical payments coverage,
◦ uninsured motorist protection.
• Auto insurance coverage insures property damage through
◦ property damage liability,

◦ collision,
◦ comprehensive physical damage.
• Auto insurance costs are determined by the driver, the car, and the
driving region.
• The risk of the driver is determined by demographics, credit history,
employment history, and driving record.
• The risk of the car is determined by its cost; safety and security features
may lower insurance costs.
• The risk of the driving region is determined by statistical incident
histories of accidents or thefts.

EXERCISES
1. In your personal finance journal or My Notes, record or chart all the

insurances you own privately or through a financial institution and/or
are entitled to through your employer. In each case, what is insured,
who is the insurer, what is the term, what are the benefits, and what is
your premium or deduction? Research online to find the details. Then
analyze your insurance in relation to your financial situation. How does
each type of insurance shift or reduce your risk or otherwise help
protect you and your assets or wealth?
2. Conduct and record a complete inventory of all your personal property.
State the current market value or replacement cost of each item. Then
identify the specific items that would cause you the greatest difficulty
and expense if they were lost, damaged, or stolen.
3. How would a renter’s insurance policy help protect your property? What
do such policies cover? See http://www.insure.com/articles/
homeinsurance/renters.html, for example, and
http://personalinsure.about.com/library/weekly/aaMMDDYYa.htm.
How much would it cost you to insure against the lost of just your laptop
or desktop computer (see, for example, http://www.nssi.com)?
4. How do auto insurance rates in your state compare with rates in other
states? Rates are based partly on the rates of accidents, injuries, and
deaths in your state. Look at your state statistics concerning highway
fatalities from the National Highway Traffic Safety Administration at
http://www-nrd.nhtsa.dot.gov/departments/nrd-30/ncsa/STSI/
USA%20WEB%20REPORT.HTM. What minimum auto insurance must you
carry by law in your state? You will find state-by-state minimum car
insurance data at http://personalinsure.about.com/cs/vehicleratings/
a/blautominimum.htm. What optional insurance do you carry over the
minimum, and why? What do you pay for car insurance, and how can
you reduce your premium?
5. What does the National Association of Insurance Commissioners
(http://www.naic.org/index_about.htm) do to protect consumers of
insurance products? How would you contact your state’s insurance
department office, and what could you learn there (see
http://www.usa.gov/directory/stateconsumer/index.shtml)?

10.2 Insuring Your Health
LEARNING OBJECTIVES
1. Define basic health care coverage and major medical insurance.

2. Identify the insured’s responsibility for costs.
3. Describe the structure of health maintenance organizations.
4. Distinguish the different accounts for private health care financing.
5. Distinguish the different programs for public health care financing.
6. Explain the purpose of long-term care insurance.
Melissa is a medical transcriptionist who runs a cleaning service on the side. She
usually clears about $24,000 per year from the cleaning service and has come to rely
on that money. One day, Melissa slips on a wet floor. She is taken by ambulance to
the local hospital, where she is treated for a badly broken wrist and released the
next day. Melissa can’t clean for about eight weeks, losing close to $6,000 in
earnings.
Soon, medical bills start to arrive. Melissa is not

concerned, because she has health insurance through Figure 10.7
her job as a medical transcriptionist. She is surprised to
find out, however, that some of the costs of this accident
are not covered, that she has a significant deductible,
and that she’ll also have to pay the difference between
what the doctors billed and what the insurance will pay.
Not only did she lose substantial cleaning earnings, but
her out-of-pocket costs are mounting as well. This
accident is beginning to be very costly. © 2010 Jupiterimages
Corporation
Melissa is discovering that health insurance is a

complicated business. The time to understand your
health coverage is before you need it. When you are
recovering from an accident or illness, you should not be concerned with your
medical bills, yet you may have to be.
According to the National Coalition on Health Care (http://www.nchc.org), “Since

1999, employment-based health insurance premiums have increased 120 percent,
compared to cumulative inflation of 44 percent and cumulative wage growth of 29
percent during the same period.”The Henry J. Kaiser Family Foundation, “Employee
311
Health Benefits: 2008 Annual Survey,” September 2008. Even where employers
“provide” health insurance as an employee benefit, in other words, workers are
paying an increasing share of the premium. In 2008, that share averaged 27
percent.National Coalition on Health Care, “Health Insurance Costs,” 2009,
http://www.nchc.org (accessed May 3, 2009). A 2005 “study found that 50 percent of
all bankruptcy filings were partly the result of medical expenses. Every 30 seconds
in the United States someone files for bankruptcy in the aftermath of a serious
health problem.”David U. Himmelstein, Deborah Thorne, Elizabeth Warren, and
Steffie Woolhandler, “Medical Bankruptcy in the United States, 2007: Results of a
National Study,” American Journal of Medicine 122, no. 8 (August 2009): 741–46.
Even if you think those numbers are exaggerated, it’s still sobering, because no
matter how much you try to take care of yourself and to be careful, no one can
evade the pure risk of injury or illness. All you can do is try to shift that risk in a
way that makes sense for your financial health.
Because of the increasing costs of health care and the increasing complexities of
paying for them, the distribution and financing of health care is much discussed
and debated in the United States, especially the roles of the federal government and
insurance providers. Regardless of the outcome of this debate, momentum is
building for change. You should be aware of changes as they occur so that you can
incorporate those changes into your budget and financial plans.
Health Insurance Coverage
There are many different kinds of coverage and plans for health insurance. You
may have group health insurance offered as an employee benefit or as a member of
a professional association. Group plans have lower costs, because the group has
some bargaining power with the insurer and can generally secure lower rates for its
members. But group plans are not necessarily comprehensive, so you may want to
supplement the group coverage with an individual health insurance policy,
available to individuals and families.
Sufficient coverage should include basic insurance21 and major medical insurance.
A basic insurance policy will cover physician expense, surgical expense, and
hospital expense.
• Physician expenses include nonsurgical treatments and lab tests.

• Surgical expenses include surgeons’ fees.
21. Health insurance that covers
the costs of physician
• Hospital expenses include room and board and other hospital charges.
expenses, surgical expenses,
and hospital expenses.
10.2 Insuring Your Health 312

Frequently, these coverages are capped or limited. For example, hospital expense
coverage is typically limited to a certain amount per day or a certain number of
days per incident. Surgeon’s fees are often capped.
The three basic coverages are usually combined under

one policy. In addition, health insurance is completed Figure 10.8
by major medical insurance22, which covers the costs
of a serious injury or illness. Depending on the extent
and the nature of your illness or injury, medical bills
can quickly exceed your basic coverage limits, so major
medical can act as an extension to those limits, saving
you from potential financial distress.
Dental insurance also supplements your basic insurance,

usually providing reimbursement for preventative
treatments and some partial payment of dental services
such as fillings, root canals, crowns, extractions,
bridgework, and dentures. Vision insurance provides for
eye care, including exams and treatment for eye
diseases, as well as for corrective lenses. Depending on © 2010 Jupiterimages
your basic coverage limits, dental and vision care could Corporation
be important for you.
Another feature of basic coverage is a prescription drug

plan. Prescriptions may be covered entirely or with a co-pay, or only if the generic
version of the drug is available. Your insurer should provide a formulary23 or a list
of drugs that are covered. Depending on your plan, prescription coverage may be
available only as a supplement to your basic coverage.
Health Insurance Costs

22. Insurance for the costs of
serious injury or illness. As health care costs and insurance premiums rise, insurers add cost offsets to make
23. A list of drugs covered by an
their policies more affordable. Those offsets may include the following:
insurer under a prescription
drug plan.
• Deductibles24—an amount payable by the insured before any expenses
24. Costs paid by the insured are assumed by the insurer.
before the insurer provides
• Co-pays25—partial payment for certain costs—for example, for
coverage.
physician’s visits or prescriptions.
25. Partial payment for certain • Coinsurance26—shared payments of expenses by insured and insurer.
costs, made by the insured.
26. Shared payments by insured

and insurer.

Each of these payment features represents responsibilities of the insured, that is,
your out-of-pocket costs. The more costs you shoulder, the less risk to the insurer,
and so the less you pay for the insurance policy. Making you responsible for initial
costs also discourages you from seeking health care more than is necessary or from
submitting frivolous health care claims.
Costs vary with coverage, coverage limits, and offsets, and they vary widely
between insurers. You should be well informed as to the specifics of your coverage,
and you should compare rates before you buy. An insurance broker can help you to
do this, and there are Web sites designed to help you explore the available options.
See, for example, the health insurance consumer guide and resource links from the
U.S. Department of Health and Human Services at http://www.ahrq.gov/consumer/
insuranceqa/.
Health Insurance and Health Care
Health insurance is sold through private insurers, nonprofit service plans, and
managed care organizations. Private insurers sell most of their plans to employers
as group plans. Individuals are far more likely to purchase insurance through a
service plan or managed care.
Private (for-profit) plans in most states are underwritten based on your age, weight,
smoking status, and health history and are generally more expensive than other
types of plans. You may have to take a medical exam, and specific preexisting
conditions—such as asthma, heart disease, anxiety, or diabetes—could be excluded
from coverage or used as grounds for increasing the cost of your premium, based on
your higher risk. Nevertheless, federal and state laws protect you from being denied
health care coverage because of any preexisting condition.
A service plan such as Blue Cross/Blue Shield, for example, consists of regional and
state-based nonprofit agencies that sell both group and individual policies. More
than half of the health insurance companies in the United States are nonprofits,
including, for example, Health Care Service Corporation and Harvard Pilgrim
Health Care as among the largest (http://www.nonprofithealthcare.org/resources/
27. Organizations or networks of
BasicFactsAndFigures-NonprofitHealthPlans9.9.08.pdf).
health care providers based on
the principle of providing
preventative care in order to Managed care organizations27 became popular in the last thirty years or so with
better health and lower costs the idea that providing preventative care would lower health care costs. Managed
of health care. Such care takes the following forms:
organizations also provide for
emergency and special
treatment services under
• Health maintenance organizations
various systems.

• Preferred provider organizations

• Exclusive provider organizations
• Point-of-service plans
• Traditional indemnity plans
The two most familiar kinds of managed care are health maintenance organizations
(HMOs) and preferred provider organizations (PPOs). A health maintenance
organization28 directly hires physicians to provide preventative, basic, and
supplemental care. Preventative care should include routine exams and screening
tests and immunizations. Basic care should include inpatient and outpatient
treatments, emergency care, maternity care, and mental health and substance
abuse services. As with any plan, the details for what defines “basic care” will vary,
and you should check the fine print to make sure that services are provided. For
example, the plan may cover inpatient hospitalizations for a limited number of days
in case of a physical illness, but inpatient hospitalization for a more limited number
of days for a mental illness.
Supplemental care typically includes the cost of vision and hearing care,
prescriptions, prosthetics devices, or home health care. Some or all of this coverage
may be limited, or may be available for an added premium. The premium paid to
the HMO is a fixed, monthly fee, and you must seek care only within the HMO’s
network of care providers.
The most serious constraint of HMOs is the limited choice of doctors and the need
to get a referral from your primary care physician (PCP) to obtain the services of
any specialist. Depending on where you live and the availability of medical
practitioners, this may or may not be an issue for you, but before joining an HMO,
you should consider the accessibility and convenience of the care that you are
allowed, as well as the limitations of the coverage. For example, if you are
diagnosed with a serious disease or need a specific surgical technique, is there an
28. An organization to provide
“managed care” through appropriate specialist in the network that you can consult? Suppose you want a
reliance on primary care second opinion? The rules differ among HMOs, but these are the kinds of questions
physicians and a network of that you should be asking. You should also be familiar with the HMO’s appeal
specialists, with an emphasis
procedures for coverage denied.
on preventative care.
29. A type of managed care in

which physicians, hospitals, The preferred provider organization (PPO)29 has a different arrangement with
and other care providers affiliated physicians: it negotiates discounted rates directly with health care
contract with an insurer to providers in exchange for making them the “preferred providers” for members
provide care at reduced rates
upon referral from the seeking care. Care by physicians outside the network may be covered, but with
insured’s primary care more limitations, or higher co-pays and deductibles. In exchange for offering the
physician. Unlike the HMO, flexibility of more choices of provider, the PPO charges a higher premium. Services
out-of-network providers may
covered are similar to those covered by an HMO.
be used.

The exclusive provider organization works much like the PPO, except that out-of-
network services are not covered at all and become out-of-pocket expenses for the
insured.
The point-of-service (POS)30 plan also uses a network of contracted, preferred

providers. As in an HMO, you choose a primary care physician who then controls
referrals to specialists or care beyond preventative and basic care. As in the PPO,
out-of-network services may be used, but their coverage is more limited, and you
pay higher out-of-pocket expenses for co-pays and deductibles.
Figure 10.9 "Managed Care Choices" shows the differences in managed care options.
Figure 10.9 Managed Care Choices
Private Health Care Financing

30. A type of managed care in
which physicians, hospitals, In the United States, if someone is not self-insured or uninsured, health insurance
and other care providers
contract with an insurer to
coverage is paid for, at least in part, by the employer. As health care costs have
provide care at reduced rates risen, employers in all industries have increasingly complained that this cost makes
upon referral from the them less competitive in global markets. As an incentive to have more people
insured’s primary care paying the costs of health care themselves and to be less dependent on employers,
physician. Unlike the HMO,
out-of-network providers may the federal government has created tax deductions for savings earmarked for use in
be used, but on a limited basis. paying for health costs. These savings plans are known as flexible spending
accounts (FSAs), health reimbursement accounts (HRAs), and health savings
31. An account created with
regular payroll deductions by accounts (HSAs).
an employee to finance
supplemental health care costs.
Monies must be expended A flexible savings account31 is used to supplement your basic coverage. It is
within a specified time period offered by employers and funded by employees: you may have a tax-exempt
or forfeited (“use it or lose it”).

deduction made from your paycheck to your flexible spending account. The money
from your FSA may be used for care expenses not normally covered by your
plan—for example, orthodonture, elder care, or child care. At the end of the year,
any money remaining in your account is forfeited; that is, it does not roll over into
the next year. Unless you can foresee expenses within the coming year, flexible
spending may not be worth the tax break.
A health reimbursement account32 is an account funded by employers. The

amount is used to pay the premiums for basic coverage with a high deductible, and
any money left over may be used for other health expenses, or, if unused, may be
carried over to the next year. The account is yours until you leave your job, when it
reverts back to your employer.
A health savings account33 (HSA) allows a tax-deductible contribution from your

paycheck to pay the premiums for catastrophic coverage with a high deductible and
whatever out-of-pocket health care costs you may have. It is employee funded,
employee managed, and employee owned. Thus, it is yours, and you may take it
with you when you change jobs.
Figure 10.10 "Differences in Private Funding of Health Care" shows the differences
between these accounts.
Figure 10.10 Differences in Private Funding of Health Care
32. An employer owned and

funded account to finance
empoyee health care costs, A health savings account shifts the responsibility for health insurance from the
with the employee choosing employer to the employee, although it still gives the employee access to lower
the type of coverage.
group rates on premiums. If you are relatively young and healthy, and your health
33. Individually owned and care need is usually just an annual physical, this seems like an advantageous plan.
financed savings accounts that However, remember that the idea of insurance is to shift risk away from you, to pay
may be used to finance health
care costs with tax-deductible someone to assume the risk for you. With a high-deductible policy, you are still
contributions.

bearing a lot of risk. If that risk has the potential to cause a financial disaster, it’s
too much.
If you have employer-sponsored health insurance and you leave your job, you may
be entitled to keep your insurance for eighteen months (or more under certain
circumstances). Under the 1985 Consolidated Budget Omnibus Reconciliation Act
(COBRA), an employee at a company with at least twenty employees who notifies
the employer of his or her intention to maintain health care coverage is entitled to
do so provided the employee pays the premiums. Some states extend this privilege
to companies with less than twenty employees, so you should check with your
state’s insurance commissioner. You may also be able to convert your group
coverage into an individual policy, although with more costly premiums.
The Health Insurance Portability and Accountability Act (HIPAA) of 1996 addresses
issues of transferring coverage, especially as happens with a change of jobs. It
credits an insured for previous periods of insurance coverage that can be used to
offset any waiting periods for coverage of preexisting conditions. In other words, it
makes it easier for someone who is changing jobs to maintain continuous coverage
of chronic conditions or illnesses.Centers for Medicare and Medicaid Services, U.S.
Department of Health and Human Services, http://www.cms.hhs.gov/
hipaaGenInfo/ (accessed November 24, 2009). (For more information, research the
U.S. Department of Health and Human Services at http://www.hhs.gov; see, for
example, http://www.hhs.gov/ocr/privacy/hipaa/administrative/statute/
hipaastatutepdf.pdf.)
Public Health Care Financing
The federal government, in concert with state governments, provides two major
programs to the general public for funding health care: Medicare and Medicaid. The
federal government also provides services to veterans of the armed forces, and
their spouses and dependents, provided they use veterans’ health care facilities and
providers (see http://www.va.gov).
Medicare34 was established in 1965 to provide minimal health care coverage for the
elderly, anyone over the age of sixty-five. Medicare offers hospital (Part A), medical
(Part B), combined medical and hospital (Part C), and prescription coverage (Part
D), as outlined in Figure 10.11 "Medicare Plans and Coverage".
34. A federal program financing

health care costs with
eligibility based on age (for
those over age sixty-five).

Figure 10.11 Medicare Plans and Coverage
Medicare is really a combination of privately and publicly funded health care; the
optional services all require some premium paid by the insured. You may not need
Medicare’s supplemental plans if you have access to supplemental insurance
provided by your former employer or by membership in a union or professional
organization.
Medicare does not cover all services. For example, it does not cover dental and
vision care, private nursing care, unapproved nursing home care, care in a foreign
country, and optional or discretionary (unnecessary) care.
Medicare also determines the limits on payments for services, but physicians may
charge more than that for their services (within limits determined by Medicare).
You would be responsible for paying the difference. For these reasons, it is
advisable to have supplemental insurance.
Marley thought she didn’t need to know anything about

Medicare, being young, single, and healthy, but then her Figure 10.12
sixty-six-year-old father developed a debilitating illness,
requiring not only medical care but also assistance with
many of his daily living activities. Suddenly, Marley was
shouldering the responsibility of arranging her father’s
care and devising a strategy for financing it. She quickly
learned about the care and limits of coverage offered by
various Medicare plans.
Medicaid35 was also established in 1965 to provide

health care based on income eligibility. It is
administered by each state following broad federal
guidelines and is jointly financed by the state and
35. A federal program financing federal government. This means that states differ
health care costs with
somewhat in the benefits or coverage they offer. If
eligibility based on income.

someone is covered by both Medicaid and Medicare,

Medicaid pays for expenses not covered by Medicare, © 2010 Jupiterimages
such as co-pays and deductibles. Together, Medicare Corporation
and Medicaid pay about 60 percent of all nursing home
costs.The Henry J. Kaiser Family Foundation, “The
Kaiser Commission on Medicaid and the Uninsured,”
January 2006, http://www.kff.org/medicaid/upload/7452.pdf (accessed April 11,
2009).
Long-Term Care Insurance
Long-term care insurance36 is designed to insure your care should you be

chronically unable to care for yourself. “Care” refers not to medical care, but to
care of “activities of daily living” (ADLs) such as bathing, dressing, toileting, eating,
and mobility, which may be impaired due to physical or mental illness or injury.
Long-term care coverage is offered as either indemnity coverage or “expense-

incurred” policies. With an indemnity policy, you will be paid a specified benefit
amount per day regardless of your costs incurred. With an “expense-incurred”
policy, you will be reimbursed for your actual expenses incurred. Both types of
policies can have limits, either for dollar amounts per day, week, or month or for
number of days or years of coverage. Newer policies are designed as integrated
policies, offering pooled benefits and specifying a total dollar limit of benefits that
may be used over an unspecified period.
Need for long-term care is anticipated in older age, although anyone of any age may
need it. When you buy the policy, you may be far away from needing the coverage.
For that reason, many policies offer benefit limits indexed to inflation, to account
for cost increases that happen before you receive benefits.
The cost of a long-term care policy varies with your age, coverage, policy features
such as inflation indexing, and current health. As with any insurance purchase, you
should be as informed as possible, comparing coverage and costs before buying.
36. Insurance to provide for

permanent assistance with
activities of daily living in the
event of disabling injury or
illness.

KEY TAKEAWAYS
• Basic health care coverage is for physician expenses, surgical expenses,

and hospital expenses; major medical insurance extends basic insurance
in case of serious illness or injury.
• The insured’s responsibility for costs can be structured as
◦ deductibles,
◦ co-pays,
◦ coinsurance.
• Health insurance is sold through private insurers, nonprofit

service plans, and managed care organizations, which may be
structured as
◦ health maintenance organizations,

◦ preferred provider organizations,
◦ exclusive provider organizations,
◦ point-of-service plans,
◦ traditional indemnity plans.
• Private health care financing may be supplemented by
◦ flexible spending accounts (FSAs),

◦ health reimbursement accounts (HRAs),
◦ health savings accounts (HSAs).
• Public health care financing is provided by federal programs: Medicare
and Medicaid.
• Long-term care insurance provides for the costs of assistance with
activities of daily living.

EXERCISES
1. What health insurance do you have, directly or as a participant in

someone else’s health insurance policy (such as a spouse)? Identify the
type of insurance in terms of the information presented in this chapter,
and list the advantages and disadvantages of carrying this type of health
insurance. Are you satisfied with the benefits and coverage in your plan?
What would you change? What do you or the insured pay for health
insurance each month, and how is it paid? Based on your research on
health insurance, how might you try to change the way you fill this need
in the future?
2. Visit the U.S. Department of Health and Human Services Web site at
http://www.ahrq.gov/consumer/insuranceqa. According to their
consumer guide to health insurance, what is indemnity insurance? What
is coinsurance? What is a deductible? How are HMO, PPO, and POS plans
different from indemnity insurance? Based on information in the
consumer guide and this chapter, what do you feel is the right health
insurance for you?
3. What is the Health Insurance Portability and Accountability Act
(HIPPAA), and why was the law enacted? Find out at
http://www.dol.gov/ebsa/faqs/faq_consumer_hipaa.html.
4. View a classic Saturday Night Live video about getting robot insurance
at http://www.robotcombat.com/video_oldglory_hi.html. Discuss with
classmates what is funny and not funny about this video. What criticism
is implied, and how might that apply to other kinds of insurance? Health
insurance and access to health care are significant issues in American
politics and life. Many Americans are uninsured, for example, and for
those who have insurance, there are critical gaps in coverage.
Meanwhile, the costs of both health insurance and health care keep
rising, and the public safety nets, such as Medicare, are continually at
risk. Conservatives and liberals have different responses to these
problems. See, for example, President Obama’s call for health care
reform as both a moral and a fiscal imperative, along with opposition
responses to his proposal, at http://www.cnn.com/2009/POLITICS/02/
24/obama.health.care/index.html. What are some current initiatives
concerning health insurance reform that may affect you? Where do you
and your classmates stand on these issues?

10.3 Insuring Your Income
LEARNING OBJECTIVES
1. Describe the purposes, coverage, and costs of disability insurance.

2. Compare the appropriate uses of term life and whole life insurance.
3. Explain the differences among variable, adjustable, and universal whole
life policies and the use of riders.
4. List the factors that determine the premiums for whole life policies.
As you have learned, assets such as a home or car should be protected from the risk
of a loss of value, because assets store wealth, so a loss of value is a loss of wealth.
Your health is also valuable, and the costs of repairing it in the case of accident or
illness are significant enough that it also requires insurance coverage. In addition,
however, you may have an accident or illness that leaves you permanently impaired
or even dead. In either case, your ability to earn income will be restricted or gone.
Thus, your income should be insured, especially if you have dependents who would
bear the consequences of losing your income. Disability insurance and life
insurance are ways of insuring your income against some limitations.
Disability Insurance
Disability insurance37 is designed to insure your income should you survive an

injury or illness impaired. The definition of “disability” is a variable feature of most
policies. Some define it as being unable to pursue your regular work, while others
define it more narrowly as being unable to pursue any work. Some plans pay partial
benefits if you return to work part-time, and some do not. As always, you should
understand the limits of your plan’s coverage.
The costs of disability insurance are determined by the features and/or conditions
of the plan, including the following:
• Waiting period
• Amount of benefits
37. Insurance to protect the
insured against the risk of • Duration of benefits
being unable to earn wages or • Cause of disability
salary as a result of injury or • Payments for loss of vision, hearing, speech, or use of limbs
illness.
323
• Inflation-adjusted benefits
• Guaranteed renewal or noncancelable clause
In general, the greater the number of these features or conditions that apply, the
higher your premium.
All plans have a waiting period from the time of disability to the collection of
benefits. Most are between 30 and 90 days, but some are as long as 180 days. The
longer the waiting period is, generally, the less the premium.
Plans also vary in the amount and duration of benefits. Benefits are usually offered
as a percent of your current wages or salary. The more the benefits or the longer
the insurance pays out, the higher the premium. Some plans offer lifetime benefits,
while others end benefits at age sixty-five (the age of Medicare eligibility).
In addition, some plans offer benefits in the following cases, all of which carry
higher premiums:
• Disability due to accident or illness

• Loss of vision, hearing, speech, or the use of limbs, regardless of
disability
• Benefits that automatically increase with the rate of inflation
• Guaranteed renewal, which insures against losing your coverage if
your health deteriorates
You may already have some disability insurance through your employer, although
in many cases the coverage is minimal. You may also be eligible for Social Security
benefits from the federal government or workers’ compensation benefit from your
state if the disability is due to an on-the-job accident. Other providers of disability
benefits include the following:
• The Veterans’ Administration (if you are a veteran)

• Automobile insurance (if the disability is due to a car accident)
• Labor unions (if you are a member)
• Civil service provisions (if you are a government employee)
You should know the coverage available to you and if you find it’s not adequate,
supplement it with private disability insurance.
10.3 Insuring Your Income 324

Life Insurance
Life insurance38 is a way of insuring that your income will continue after your
death. If you have a spouse, children, parents, or siblings who are dependent on
your income or care, your death would create new financial burdens for them. To
avoid that, you can insure your dependents against your loss, at least financially.
There are many kinds of life insurance policies. Before purchasing one, you should
determine what it is you want the insurance to accomplish for your survivors. What
do you want it to do?
• Pay off the mortgage?

• Put your kids through college?
• Provide income so that your spouse can be home with the kids and not
be forced out into the workplace?
• Provide alternative care for your elderly parents or dependent
siblings?
• Cover the costs of your medical expenses and funeral?
• Avoid estate taxes?
These are uses of life insurance. Your goals for your life insurance will determine
how much benefit you need and what kind of policy you need. Weighed against that
are its costs—the amount of premium that you pay and how that fits into your
current budget.
Sam and Maggie have two children, ages three and five.
Maggie works as a credit analyst in a bank. Sam looks Figure 10.13
after the household and the children and Maggie’s
elderly mother, who lives a couple of blocks away. He
does her grocery shopping, cleans her apartment, does
her laundry, and runs any errands that she may need
done. Sam and Maggie live in a condo they bought,
financed with a mortgage. They have established college
savings accounts for each child, and they try to save
regularly. © 2010 Jupiterimages
Corporation
Sam and Maggie need to insure both their lives, because

the loss of either would cause the survivors financial
hardship. With Maggie’s death, her earnings would be
38. Insurance to compensate
beneficiaries against the
gone, which is how they pay the mortgage and save for their children’s education.
financial consequences of the Insurance on her life should be enough to pay off the mortgage and fund their
death of the insured. children’s college educations, while providing for the family’s living expenses,

unless Sam returns to the workforce. With Sam’s death, Maggie would have to hire
someone to keep house and care for their children, and also someone to keep her
mother’s house and provide care for her. Insurance on Sam’s life should be enough
to maintain everyone’s quality of living.
Term Insurance
Maggie’s income provides for three expenditures: the mortgage, education savings,
and living expenses. While living expenses are an ongoing or permanent need, the
mortgage payment and the education savings are not: eventually, the mortgage will
be paid off and the children educated. To cover permanent needs, Maggie and Sam
should consider permanent insurance, also known as whole life39, straight life, or
cash value insurance. To insure those two temporary goals of paying the mortgage
and college tuitions, Maggie and Sam could consider temporary or term insurance.
Term insurance40 is insurance for a limited time period, usually one, five, ten, or
twenty years. After that period, the coverage stops. It is used to cover financial
needs for a limited time period—for example, to cover the balance due on a
mortgage, or education costs. Premiums are lower for term insurance, because the
coverage is limited. The premium is based on the amount of coverage and the
length of the time period covered.
A term insurance policy may have a renewability option, so that you can renew the
policy at the end of its term, or it may have a conversion option, so that you can
convert it to a whole life policy and pay a higher premium. If it is multiyear level
term or straight term, the premium will remain the same over the term of
coverage.
Decreasing term insurance pays a decreasing benefit as the term progresses, which
may make sense in covering the balance due on a mortgage, which also decreases
with payments over time. On the other hand, you could simply buy a one-year term
policy with a smaller benefit each year and have more flexibility should you decide
to make a change.
A return-of-premium (ROP) term policy will return the premiums you have paid if
you outlive the term of the policy. On the other hand, the premiums on such
39. Life insurance providing policies are higher, and you may do better by simply buying the regular term policy
coverage until the insured’s
death; it can also be used as an and saving the difference between the premiums.
investment instrument.
40. Life insurance providing

coverage for a specified period
of time.

Term insurance is a more affordable way to insure against a specific risk for a
specific time. It is pure insurance, in that it provides risk shifting for a period of
time, but unlike whole life, it does not also provide a way to save or invest.
Whole Life Insurance
Whole life insurance is permanent insurance. That is, you pay a specified premium
until you die, at which time your specified benefit is paid to your beneficiary. The
amount of the premium is determined by the amount of your benefit and your age
and life expectancy when the policy is purchased.
Unlike term insurance, where your premiums simply pay for your coverage or risk
shifting, a whole life insurance policy has a cash surrender value41 or cash value
that is the value you would receive if you canceled the policy before you die. You
can “cash out” the policy and receive that cash value before you die. In that way,
the whole life policy is also an investment vehicle; your premiums are a way of
saving and investing, using the insurance company as your investment manager.
Whole life premiums are more than term life premiums because you are paying not
only to shift risk but also for investment management.
A variable life42 insurance policy has a minimum death benefit guaranteed, but the
actual death benefit can be higher depending on the investment returns that the
policy has earned. In that case, you are shifting some risk, but also assuming some
risk of the investment performance.
An adjustable life43 policy is one where you can adjust the amount of your benefit,
and your premium, as your needs change.
41. The value of a whole life

policy—the cash available for A universal life44 policy offers flexible premiums and benefits. The benefit can be
the policyholder—if the policy increased or decreased without canceling the policy and getting a new one (and
is canceled before the death of thus losing the cash value, as in a basic whole life policy). Premiums are added to
the insured.
the policy’s cash value, as are investment returns, while the insurer deducts the
42. Life insurance that provides a cost of insurance (COI) and any other policy fees.
guaranteed minimum benefit
with potential to be greater
depending on investment When purchased, universal life policies may be offered with a single premium
performance.
payment, a fixed (and regular) premium payment until you die, or a flexible
43. Benefits and premium can be premium where you can determine the amount of each premium, so long as the
adjusted without cancellation cash value in the account can cover the insurer’s COI.
of the policy.
44. Benefits and premiums are

flexible, in terms of both Figure 10.14 "Life Insurance Options" shows the life insurance options.
timing and amounts.

Figure 10.14 Life Insurance Options
So, is it term or whole life? When you purchase a term life policy, you purchase and
pay for the insurance only. When you purchase a whole life policy, you purchase
insurance plus investment management. You pay more for that additional service,
so its value should be greater than its cost (in additional premiums). Whole life
policies take some analysis to figure out the real investment returns and fees, and
the insurer is valuable to you only if it is a better investment manager than you
could have otherwise. There are many choices for investment management. Thus,
the additional cost of a whole life policy must be weighed against your choices
among investment vehicles. If it’s better than your other choices, then you should
buy the whole life. If not, then buy term life and save or invest the difference in the
premiums.
Choosing a Policy
All life insurance policies have basic features, which then can be customized with a
rider45—a clause that adds benefits under certain conditions. The standard features
include provisions that protect the insured and beneficiaries in cases of missed
premium payments, fraud, or suicide. There are also loan provisions granted, so
that you can borrow against the cash value of a whole life policy.
Riders are actually extra insurance that you can purchase to cover less common
circumstances. Commonly offered riders include
• a waiver of premium payment if the insured becomes completely

45. A clause to a policy that adds disabled,
specific benefits under specific • a double benefit for accidental death,
conditions.

• guaranteed insurability allowing you to increase your benefit without

proof of good health,
• cost of living protection that protects your benefit from inflation,
• accelerated benefits that allow you to spend your benefit before your
death if you need to finance long-term care.
Finally, you need to consider the settlement options offered by the policy: the ways
that the benefit is paid out to your beneficiaries. The three common options are
• as a lump sum, paid out all at once;

• in installments, paid out over a specified period;
• as interest payments, so that a series of interest payments is made to
the beneficiaries until a specified time when the benefit itself is paid
out.
You would choose the various options depending on your beneficiaries and their
anticipated needs. Understanding these features, riders, and options can help you
to identify the appropriate insurance product for your situation. As with any
purchase, once you have identified the product, you need to identify the market
and the financing.
Many insurers offer many insurance products, usually sold through brokers or
agents. Agents are paid on commission, based on the amount of insurance they sell.
A captive agent sells the insurance of only one company, while an independent
agent sells policies from many insurers. You want a licensed agent that is
responsive and will answer questions patiently and professionally. If you die, this
may be the person on whom your survivors will have to depend to help them
receive their benefits in a troubling time.
You will have to submit an application for a policy and

may be required to have a physical exam or release Figure 10.15
medical records to verify your physical condition.
Factors that influence your riskiness are your family
medical history, age and weight, and lifestyle choices
such as smoking, drinking, and drug use. Your risks will
influence the amount of your premiums.
Having analyzed the product and the market, you need

to be sure that the premium payments are sustainable
for you, that you can add the expense in your operating
budget without creating a budget deficit.

Life Insurance as a Financial Planning Decision

Unlike insuring property and health, life insurance can Corporation
combine two financial planning functions: shifting risk
and saving to build wealth. The decision to buy life
insurance involves thinking about your choices for both
and your opportunity cost in doing so.
Life insurance is about insuring your earnings even after your death. You can create
earnings during your lifetime by selling labor or capital. Your death precludes your
selling labor or earning income from salary or wages, but if you have assets that can
also earn income, they may be able to generate some or even enough income to
insure the continued comfort of your dependents, even without your salary or
wages.
In other words, the larger your accumulated asset base, the greater its earnings,
and the less dependent you are on your own labor for financial support. In that
case, you will need less income protection and less life insurance. Besides life
insurance, another way to protect your beneficiaries is to accumulate a large
enough asset base with a large enough earning potential.
If you can afford the life insurance premiums, then the money that you will pay in
premiums is currently part of your budget surplus and is being saved somehow. If it
is currently contributing to your children’s education savings or to your retirement
plan, you will have to weigh the value of protecting current income against insuring
your children’s education or your future income in retirement. Or that surplus
could be used toward generating that larger asset base.
These are tough decisions to weigh because life is risky. If you never have an
accident or illness and simply go through life earning plenty and paying off your
mortgage and saving for retirement and educating your children, then are all those
insurance premiums just wasted? No. Since your financial strategy includes
accumulating assets and earning income to satisfy your needs now or in the future,
you need to protect those assets and income, at least by shifting the risk of losing
them through a chance accident. At the same time, you must make risk-shifting
decisions in the context of your other financial goals and decisions.

KEY TAKEAWAYS
• Disability insurance insures your income against an accident or illness

that leaves your earning ability impaired.
• Disability insurance coverage and costs vary.
• Life insurance is designed to protect dependents against the loss of your
income in the event of your death.
• Term insurance provides life insurance coverage for a specified period
of time.
• Whole life insurance provides life insurance coverage until the insured’s
death.
• Whole life insurance has a cash surrender value and thus can be used as
an investment instrument as well as a way of shifting risk.
• Variable, adjustable, and universal life policies offer more flexibility of
benefits and premiums.
• Riders provide more specific coverage.
• Premiums are determined by the choice of benefits and riders and the
risk of the insured, as assessed by medical history and lifestyle choices.

EXERCISES
1. Find out about workers’ compensation at http://www.dol.gov/owcp/.

What does the federal Office of Workers’ Compensation Programs do,
and what specific disabilities are covered in the programs that the OWCP
administers? Find out what programs are available in your state for
workers’ compensation covering industrial and workplace accidents at
http://www.ic.nc.gov/ncic/pages/all50.htm. What is the role of the U.S.
Department of Labor’s Occupational Safety & Health Administration
(OSHA) in preventing workplace illness and injury? Find out at
http://www.osha.gov/.
2. Find information about unemployment compensation at

http://www.dol.gov/dol/topic/unemployment-insurance/ and
http://www.policyalmanac.org/social_welfare/archive/
unemployment_compensation.shtml to answer the following
questions.
a. If you are involuntarily unemployed, do the federal and state

unemployment compensation programs replace your wages?
b. Are you entitled to unemployment compensation if you
choose to be unemployed temporarily?
c. Does it matter what kind of a job you have or how much
income you earn?
d. What does it mean to be involuntarily unemployed?
e. Where does the money come from?
f. If you have seasonal employment, can you collect
unemployment to cover the off-season?
g. If you are eligible, how long can you collect unemployment?
h. Is the money you receive from unemployment compensation
taxable?
i. If you became unemployed in your state, how would your
income be insured, and what could you expect from your
state unemployment compensation program?
3. Read advice on choosing insurance from The Motley Fool at
http://www.fool.com/insurancecenter/life/life.htm. What are two
situations in which purchasing life insurance might not be a good choice
for you? According to the Insurance Information Institute
(http://www.iii.org/individuals/life/buying/pickacompany/), what
factors should you consider when choosing a life insurance company?

Chapter 11
Personal Risk Management: Retirement and Estate Planning
Introduction
While insurance is about protecting what you have, retirement and estate planning
is about protecting what you may have in the future. Insuring what you have means
finding the best way to protect it. Retirement planning, on the other hand, means
finding the best way to protect the life that you’d like to be living after you stop
earning income from employment. Estate planning involves protecting what you
have even after your death. So retirement planning and estate planning are plans to
create and then protect an accumulation of wealth.
Both types of planning also ask you to ask some of the following questions that you
really can’t answer:
• What will my life be like when I retire?

• Will I have a spouse or partner?
• Dependents?
• A home?
• A mortgage?
• Will I be disabled?
• Where will I live?
• What will I do?
• What would I like to do?
• When I die, will I have a taxable estate?
Planning, especially for retirement, should start as early as possible, allowing the
most time for savings to occur and accrue. Ironically, that’s when it is hardest to try
to imagine answers to these questions. Understanding the practical means to
planning and saving for retirement can help you get started. If your plans are
flexible, they can adapt to the unexpected as it happens, which it inevitably will.
333
Chapter 11 Personal Risk Management: Retirement and Estate Planning
11.1 Retirement Planning: Projecting Needs
LEARNING OBJECTIVES
1. Identify the factors required to estimate savings for retirement.

2. Estimate retirement expenses, length of retirement, and the amount
saved at retirement.
3. Calculate relationships between the annual savings required and the
time to retirement.
Retirement planning involves the same steps as any other personal planning: figure
out where you’d like to be and then figure out how to get there from where you are.
More formally, the first step is to define your goals, even if they are no more
specific than “I want to be able to afford a nice life after I stop getting a paycheck.”
But what is a “nice life,” and how will you pay for it?
It may seem impossible or futile to try to project your retirement needs so far from
retirement given that there are so many uncertainties in life and retirement may be
far away. But that shouldn’t keep you from saving. You can try to save as much as
possible for now, with the idea that your plans will clarify as you get closer to your
retirement, so whatever money you have saved will give you a head start.
Chris and Sam were young urban professionals until

their children were born. Tired of pushing strollers Figure 11.1
through the subways, they bought a home in the
suburbs. They are happy to provide a more idyllic
lifestyle for their kids but miss the “buzz” and
convenience of their urban lifestyle. When their
children are on their own and Chris and Sam are ready
to retire, they would like to sell their home and move
back into the city.
Corporation
Chris and Sam are planning to use the value of their
house to finance a condo in the city, but they also know
that real estate prices are often higher in the more
desirable urban areas and that living expenses may be
higher in the future. Now in their midthirties, Chris and Sam are planning to retire
in thirty years.
334
Chris and Sam need to project how much money they will need to have saved by the
time they wish to retire. To do that, they need to project both their future capital
needs (to buy the condo) and their future living expense in retirement. They also
need to project how long they may live after retirement, or how many years’ worth
of living expenses they will need, so that they won’t outlive their savings.
They know that they have thirty years over which to save this money. They also
know, as explained in Chapter 4 "Evaluating Choices: Time, Risk, and Value", that
time affects value. Thus, Sam and Chris need to project the rate of compounding for
their savings, or the rate at which time will affect the value of their money.
To estimate required savings, in other words, you need to estimate the following:
• Expenses in retirement
• The duration of retirement
• The return on savings in retirement
As difficult as these estimations seem, because it is a long time until retirement and
a lot can happen in the meantime, you can start by using what you know about the
present.
Estimating Annual Expenses
One approach is to assume that your current living expenses will remain about the
same in the future. Given that over the long run, inflation affects the purchasing
power of your income, you factor in the effect inflation may have so that your
purchasing power remains the same.
For example, say your living expenses are around $25,000 per year and you’d like to
have that amount of purchasing power in retirement as well. Assuming your costs
of living remain constant, if you are thirty years from retirement, how much will
you be spending on living expenses then?
The overall average annual rate of inflation in the United States is about 3.25
percent,The average is calculated over the period from 1913 to 2009. U.S. Bureau of
Labor Statistics, http://www.bls.gov/cpi/ (accessed May 1, 2009). so you would have
to spend $25,000 × (1 + 0.0325)30 = $65,269 per year to maintain your standard of
living thirty years from now. Put another way, thirty years from now, one dollar
will buy only about thirty-eight cents worth of today’s expenses. This calculation
comes from the relationship of time and value, studied in Chapter 4 "Evaluating
Choices: Time, Risk, and Value". In this case, $25,000 is the present value of your
11.1 Retirement Planning: Projecting Needs 335

expenses, and you are looking for the future value, given that your expenses will
appreciate at a rate of 3.25 percent per year for thirty years.
As you can see, you would need about two-and-a-half times your current spending
just to live the life you live now. Fortunately, your savings won’t be just “sitting
there” during that time. They, too, will be compounding to keep up with your
needs.
You may use your current expenses as a basis to project a more or less expensive
lifestyle after retirement. You may anticipate expenses dropping with fewer
household members and dependents, for example, after your children have grown.
Or you may wish to spend more and live a more comfortable life, doing things
you’ve always wanted to do. In any case, your current level of spending can be a
starting point for your estimates.
Estimating Length of Retirement
How much you need to have saved to support your annual living expenses after
retirement depends on how long those expenses continue or how long you’ll live
after retirement. In the United States, life expectancy at age sixty-five has increased
dramatically in the last century, from twelve to seventeen years for males and from
twelve to twenty years for females, due to increased access to health care, medical
advances, and healthier lives before age sixty-five.U.S. Department of Health and
Human Services, “Health, United States, 2008: With Special Feature on the Health of
Young Adults (Health United States),” Center for Disease Control, National Center
for Health Statistics, 2008. Figure 11.2 "Life Expectancy at Age 65 in the United
States, 1970–2005" shows the data from 1970 to 2005.

Figure 11.2 Life Expectancy at Age 65 in the United States, 1970–2005
If life expectancy continues to increase at these rates, in thirty years your life
expectancy at age sixty-five could be twenty-eight to thirty years. In that case, your
retirement savings will have to provide for your living expenses for as long as thirty
years. Put another way, at age thirty-five you have thirty years to save enough to
support you for thirty years after that.
Estimating the Amount Needed at Retirement
You can use what you know about time and value (from Chapter 4 "Evaluating
Choices: Time, Risk, and Value") to estimate the amount you would need to have
saved up by the time you retire. Your annual expenses in retirement are really a
series of cash flows that will grow by the rate of inflation. At the same time, your
savings will grow by your rate of return, even after you are making withdrawals to
cover your expenses.
Say that when you retire, you have your retirement funds invested so they are
earning a return of 5 percent per year. Assume an annual inflation rate of 3.25
percent and that your annual expenses when you retire are $65,269 (as adjusted for
inflation in the example above).

Figure 11.3 "Estimating Annual Expenses and Savings Needed at Retirement" shows
what your situation would look like.
Figure 11.3 Estimating Annual Expenses and Savings Needed at Retirement
The amount you need at retirement varies with the expected rate of return on your
savings. While you are retired, you will be drawing income from your savings, but
your remaining savings will still be earning a return. The more return your savings
can earn while you are retired, the less you have to have saved by retirement. The
less return your savings can earn in retirement, the more you need to have saved
before retirement.
In Figure 11.3 "Estimating Annual Expenses and Savings Needed at Retirement", the
total amount needed at retirement is only about $1.5 million if your remaining
savings will earn 5 percent while you are retired, but if that rate of return is only 2
percent, you would have to begin retirement with almost $2.5 million.
Let’s assume your return on savings is 5 percent. If you want to have $1,590,289 in
thirty years when you retire, you could deposit $367,957 today and just let it

compound for thirty years without a withdrawal. But if you plan to make an annual
investment in your retirement savings, how much would that have to be?
Estimating the Annual Savings for Retirement
In the example above, if you make regular annual deposits into your retirement
account for the next thirty years, each deposit would have to be $23,936, assuming
that your account will earn 5 percent for in thirty years. If the rate of return for
your savings is less, you would have to save more to have more at retirement. If
your retirement savings can earn only 2 percent, for example, you would have to
deposit $60,229 per year to have $2,443,361 when you retire. Your retirement
account grows through your contributions and through its own earnings. The more
your account can earn before you retire, the less you will have to contribute to it.
On the other hand, the more you can contribute to it, the less it has to earn.
The time you have to save until retirement can make a big difference to the amount
you must save every year. The longer the time you have to save, the less you have to
save each year to reach your goal. Figure 11.4 "Time to Retirement and Annual
Savings Required" shows this idea as applied to the example above, assuming a 5
percent return on savings and a goal of $1,590,289.
Figure 11.4 Time to Retirement and Annual Savings Required
The longer the time you have to save, the sooner you start saving, and the less you
need to save each year. Chris and Sam are already in their thirties, so they figure
they have thirty years to save for retirement. Had they started in their twenties and
had forty years until retirement, they would not have to save so much each year. If
they wait until they are around fifty, they will have to save a lot more each year.
The more you have to save, the less disposable income you will have to spend on
current living expenses, making it harder to save. Clearly, saving early and
regularly is the superior strategy.

When you make these calculations, be aware that you are using estimates to figure
the money you’ll need at retirement. You use the expected inflation rate, based on
its historic average, to estimate annual expenses, historical statistics on life
expectancy to estimate the duration of your retirement, and an estimate of future
savings returns. Estimates must be adjusted because things change. As you progress
toward retirement, you’ll want to reevaluate these numbers at least annually to be
sure you are still saving enough.
KEY TAKEAWAYS
• To estimate required savings, you need to estimate
◦ expenses in retirement, based on lifestyle and adjusted for

inflation;
◦ the duration of retirement, based on age at retirement and
longevity;
◦ the return on savings in retirement.
• You must save more for retirement if
◦ expenses are higher,

◦ duration of retirement is longer,
◦ the return on savings in retirement is less.
• Your annual savings for retirement also depends on the time until
retirement; the longer the time that you have to save, the less you need
to save each year.

EXERCISES
1. Write in your personal finance journal or My Notes your ideas and

expectations for your retirement. At what age do you want to retire?
How many years do you have to prepare before you reach that age? Will
you want to stop working at retirement? Will you want to have a
retirement business or start a new career? Where and how would you
like to live? How do you think you would like to spend your time in
retirement? How much have you saved toward retirement so far?
2. Experiment with the retirement planning calculator at MSN Money
(http://moneycentral.msn.com/retire/planner.aspx). What will you
have saved for retirement by the time you retire? What will you need to
live in retirement without income from employment? How old will you
be when your retirement savings run out? Run several combinations of
estimates to get an idea of how and why you should plan to save for
retirement. Then sample the Kiplinger’s articles about saving for
retirement at http://moneycentral.msn.com/ content/
Retirementandwills/Createaplan/P142702.asp. According to the lead
article, “The Basics: How Much Do You Need to Retire?” what
percentage of annual income should young workers in their twenties
and thirties today plan to invest in retirement savings accounts?

11.2 Retirement Planning: Ways to Save
LEARNING OBJECTIVES
1. Compare and contrast employer, government, and individual retirement

plans.
2. Explain the differences between a defined benefit plan and a defined
contribution pension plan.
3. Summarize the structure and purpose of Social Security.
4. State the difference between a Traditional IRA and a Roth IRA.
5. Identify retirement plans for the self-employed.
While knowing the numbers clarifies the picture of your needs, you must reconcile
that picture with the realities that you face now. How will you be able to afford to
save what you need for retirement?
There are several savings plans structured to help you save—some offer tax
advantages, some don’t—but first you need to make a commitment to save.
Saving means not spending a portion of your disposable income. It means delaying
gratification or putting off until tomorrow what you could have today. That is often
difficult, as you have many demands on your disposable income. You must weigh
the benefit of fulfilling those demands with the cost of not saving for retirement,
even though benefit in the present is much easier to credit than benefit in the
future. Once you resolve to save, however, employer, government, and individual
retirement plans are there to help you.
Employer Retirement Accounts
Employers may sponsor pension or retirement plans for their employees as part of
1. A pension plan sponsored by
an employer in which the the employees’ total compensation. There are two kinds of employer-sponsored
employer commits to providing plans: defined benefit plans and defined contribution plans.
a specific amount of benefit
based on wages and tenure to
retired employees. A defined benefit plan1 is a retirement plan, sometimes called a pension plan2,
funded by the employer, who promises the employee a specific benefit upon
2. An employer-sponsored,
defined benefit plan providing retirement. The employer can be a corporation, labor union, government, or other
a regular, specified amount of organization that establishes a retirement plan for its employees. In addition to (or
pension, based on wages and instead of) a defined benefit plan, an employer may also offer a profit-sharing plan,
years of service.
342
a stock bonus plan, an employee stock ownership plan (ESOP), a thrift plan, or other
plan. Each type of plans has advantages and disadvantages for employers and
employees, but all are designed to give employees a way to save for the future and
employers a way to attract and keep employees.
The payout for a defined benefit plan is usually an annual or monthly payment for
the remainder of the employee’s life. In some defined benefit plans, there is also a
spousal or survivor’s benefit. The amount of the benefit is determined by your
wages and length of service with the company.
Many defined benefit plans are structured with a vesting3 option that limits your
claim on the retirement fund until you have been with the company for a certain
length of time. For example, Paul’s employer has a defined benefit plan that
provides for Paul to be 50 percent vested after five years and fully vested after
seven years. If Paul were to leave the company before he had worked there for five
years, none of his retirement fund would be in his account. If he left after six years,
half his fund would be kept for him; after ten years, all of it would be.
With a defined benefit plan your income in retirement is constant or “fixed,” and it
is the employer’s responsibility to fund your retirement. This is both an advantage
and a disadvantage for the employee. Having your employer fund the plan is an
advantage, but having a fixed income in retirement is a drawback during periods of
inflation when the purchasing power of each dollar declines. In some plans, that
drawback is offset by automatic cost of living increases.
Defined benefit plans also carry some risk. Most companies reserve the right to
change or discontinue their pension plans. Furthermore, the pension payout is only
as good as the company that pays it. If the company defaults, its pension obligations
may be covered by the Pension Benefit Guaranty Corporation (PBGC)4, an
independent federal government agency. If not, employees are left without the
benefit. Even if the company is insured, the PGBC may not cover 100 percent of
employees’ benefits.
Founded in 1974, the PBGC is funded by insurance premiums paid by employers who
sponsor defined benefit plans. If a pension plan ends (e.g., through the employer’s
3. The process of earning full bankruptcy) the PBGC assumes pensions payments up to a limit per employee.
ownership in an employer-
Currently, the PBGC pays benefits to approximately 640,000 retirees and insures the
sponsored retirement plan
according to length of service. pensions of about 1,305,000 employees.The Pension Benefit Guaranty Corporation,
“Mission Statement,” http://www.pbgc.gov/about/about.html (accessed May 1,
4. An agency of the federal
2009). There is some concern, however, that if too many defined benefit sponsors
government that guarantees
defined benefit pensions in the fail, as could happen in a widespread recession, the PBGC would not be able to fully
case of employer default. fund its obligations.
11.2 Retirement Planning: Ways to Save 343

To avoid the responsibility for employee retirement funds, more and more
employers sponsor defined contribution retirement plans5. Under defined
contribution plans, each employee has a retirement account, and both the
employee and the employer may contribute to the account. The employer may
contribute up to a percentage limit or offer to match the employee’s contributions,
up to a limit. With a matching contribution, if employees choose not to contribute,
they lose the opportunity of having the employer’s contribution as well as their
own. The employee makes untaxed contributions to the account as a payroll
deduction, up to a maximum limit specified by the tax code. The maximum for
defined contribution plans is 25 percent of the employee’s compensation, with a cap
in 2009 of $49,000. Defined contribution plans known as 401(k) plans had a
maximum contribution limit in 2009 of $16,500.
Defined contribution plans have become increasingly popular since section 401(k)
was introduced into the tax code in 1978. The 401(k) plans6—or 403b plans for
employees of nonprofits and 457 plans for employees of government
organizations—offer employees a pretax (or tax-deferred) way to save for
retirement to which employers can make a tax-deductible contribution.
The advantages of a 401(k) for the employee are the

plan’s flexibility and portability and the tax benefit. A Figure 11.5
defined contribution account belongs to the employee
and can go with the employee when he or she leaves
that employer. For the employer, there is the lower cost
and the opportunity to shift the risk of investing funds
onto the employee. There is a ceiling on the employer’s
costs: either a limited matching contribution or a limit
set by the tax code.
The employer offers a selection of investments, but the

5. A pension plan sponsored by
an employer in which the employee chooses how the funds in his or her account
employer commits to providing are diversified and invested. Thus, the employee
a specific amount of assumes the responsibility—and risk—for investment
contribution to a retirement
returns. The employer’s contributions are a benefit to
account owned by an active
employee. the employee. Employers can also make a contribution © 2010 Jupiterimages
with company stock, which can create an undiversified Corporation
6. An employer-sponsored
account. A portfolio consisting only of your company’s
defined contribution plan.
Contributions may be made by stock exposes you to market risk should the company
employer, employee, or both. not do well, in which case, you may find yourself losing
The employee’s contributions both your job and your retirement account’s value.
are tax deferred until
distribution after age 59.5 and
are limited by the Internal
Revenue Code.

U.S. Government’s Retirement Account
The federal government offers a mandatory retirement plan for all citizens except
federal government employees and railroad workers, known as Social Security7.
Social Security is funded by a mandatory payroll tax shared by employee and
employer. That tax, commonly referred to as Federal Insurance Contributions Act
(FICA), also funds Medicare (see Chapter 10 "Personal Risk Management:
Insurance"). Social Security was signed into law by President Franklin D. Roosevelt
in 1935 to provide benefits for old age and survivors and disability insurance for
workers (OASDI). The Social Security Administration (SSA) was established to
manage these “safety nets.”
Figure 11.6 President Franklin D. Roosevelt Signing the Social Security Act, August 14, 1935Library of Congress
photo, LC-US262-123278, http://www.ssa.gov/history/fdrsign.html (accessed May 1, 2009).
We can never insure one hundred percent of the population against one hundred
percent of the hazards and vicissitudes of life. But we have tried to frame a law
which will give some measure of protection to the average citizen and to his family
against the loss of a job and against poverty-ridden old age…It is, in short, a law
that will take care of human needs and at the same time provide for the United
States an economic structure of vastly greater soundness.
- Franklin D. Roosevelt, August 14, 1935Franklin D. Roosevelt, “Statement on

Signing the Social Security Act,” August 14, 1935,
7. The mandatory retirement http://www.fdrlibrary.marist.edu/odssast.html (accessed May 1, 2009).
program sponsored by the U.S.
government to provide
supplemental retirement
Data provided by the SSA show that almost 51,500,000 beneficiaries receive an
income. It is funded by a tax
(FICA) paid by employers and average monthly benefit of $1,057. The federal government’s total annual payment
employees and by self- of benefits totals $653 billion. Most of the beneficiaries are retirees (63.6 percent) or
employed individuals who act their spouses and children (5.7 percent), but there are also survivors, widows, and
as both employer and
employee.
orphans receiving about 12.6 percent of benefits and disabled workers, spouses, and

children receiving approximately 18.3 percent of benefits.U.S. Social Security

Administration, “Monthly Statistical Snapshot, March 2009,” 2009,
http://www.ssa.gov/policy/docs/quickfacts/stat_snapshot/ (accessed May 1, 2009).
Social Security is not an automatic benefit but an entitlement. To qualify for

benefits, you must work and contribute FICA taxes for forty quarters (ten years).
Retirement benefits may be claimed as early as age sixty-two, but full benefits are
not available until age sixty-seven for workers born in 1960 or later. If you continue
to earn wage income after you begin collecting Social Security but before you reach
full retirement age, your benefit may be reduced. Once you reach full retirement
age, your benefit will not be reduced by additional wage income.
The amount of your benefit is calculated based on the

amount of FICA tax paid during your working life and Figure 11.7
your age at retirement. Up to 85 percent of individual
Social Security benefits may be taxable, depending on
other sources of income.Retrieved from the Social
Security Administration archives,
http://www.socialsecurity.gov/history/
fdrstmts.html#signing (accessed November 23, 2009).
Each year, the SSA provides each potential, qualified
beneficiary with a projection of the expected monthly © 2010 Jupiterimages
benefit amount (in current dollars) for that individual Corporation
based on the individual’s wage history.
Social Security benefits represent a large expenditure

by the federal government, and so the program is often the subject of debate.
Economists and politicians disagree on whether the system is sustainable. As the
population ages, the ratio of beneficiaries to workers increases—that is, there are
more retirees collecting benefits relative to the number of workers who are paying
into the system.
Many reforms to the system have been suggested, such as extending the eligibility
age, increasing the FICA tax to apply to more income (right now it applies only to a
limited amount of wages, but not to income from interest, dividends, or investment
gains), or having workers manage their Social Security accounts the same way they
manage 401(k) plans. Some of these proposals are based on economics, some on
politics, and some on social philosophy. Despite its critics, Social Security remains a
popular program on which many Americans have come to rely. You should,
however, be aware that Social Security can be amended and faces possible
underfunding.

Keep in mind that in 1935 when Social Security was created, life expectancy for
American males was only sixty-five, the age of Social Security eligibility. Social
Security was never meant to be a retirement income, but rather a supplement to
retirement income, merely “some measure of protection against…poverty-ridden
old age.”Retrieved from the Social Security Administration archives,
http://www.socialsecurity.gov/history/fdrstmts.html#signing (accessed November
23, 2009).
As part of the Federal Employees Retirement System (FERS), the U.S. government
also offers special retirement plans to its employees, including a Thrift Savings Plan
(TSP) for civilians employed by the United States and members of the uniformed
services (i.e., Army, Navy, Air Force, Marine Corps, Coast Guard, National Oceanic
and Atmospheric Administration, and Public Health Service).
Federal, state, and local government plans; plans for

public school teachers and administrators; and church Figure 11.8
plans are exempt from the rules of the Employee
Retirement Income Security Act of 1974 (ERISA) and
from some rules that govern retirement plans of private
employers under the Internal Revenue Code. In some
states, public school teachers pay into a state retirement
system and do not pay federal Social Security taxes (or
receive Social Security benefits) for the years they are
working as teachers. © 2010 Jupiterimages
Corporation
Nevertheless, many plans for public employees are

defined benefit plans providing annuities upon
retirement, similar to but separate from plans for
employees in the private sector.
Individual Retirement Accounts
Any individual can save for retirement without a special “account,” but since the
government would like to encourage retirement savings, it has created tax-
advantaged accounts to help you do so. Because these accounts provide tax benefits
as well as some convenience, it is best to use them first in planning for retirement,
although their use may be limited.
Individual retirement accounts (IRAs) were created in 1974 by ERISA. They were
initially available only to employees not covered by an employer’s retirement plan.
In 1981, participation was amended to include everyone under the age of
70.5.Wikipedia, “Legislative History of IRAs,” http://en.wikipedia.org/wiki/

Individual_retirement_account (accessed May 23, 2012). IRAs are personal

investment accounts, and as such may be invested in a wide range of financial
products: stocks, bonds, certificate of deposits (CDs), mutual funds, and so on. Types
of IRAs differ in terms of tax treatment of contributions, withdrawals, and in the
limits of contributions.
The Traditional IRA8 is an account funded by tax-deductible and/or nondeductible

contributions. Deductible contributions are taxed later as funds are withdrawn, but
nondeductible contributions are not. In other words, you either pay tax on the
money as you put it in, or you pay tax on it as you take it out.
A great advantage of a Traditional IRA is that principal appreciation (interest,

dividend income, or capital gain) is not taxed until the funds are withdrawn.
Withdrawals may begin without penalty after the age of 59.5. Funds may be
withdrawn before age 59.5, but with penalties and taxes applied. Contributions may
be made until age 70.5, at which time required minimum distributions
(withdrawals) of funds must begin.
Because they create tax advantages, contributions to a Traditional IRA are limited,
currently up to $5,000 (or $6,000 for someone over the age of fifty). That limit on
deductible contributions becomes smaller (the tax benefit is phased out) as income
rises. The Internal Revenue Service (IRS) provides a worksheet to calculate how
much of your contribution is taxable with your personal income tax return (Form
1040).
For the Roth IRA9, created in 1997, contributions are not tax deductible, but
withdrawals are not taxed. You can continue to contribute at any age, and you do
not have to take any minimum required distribution. The great advantage of a Roth
IRA is that capital appreciation is not taxed.
As with the Traditional IRA, contributions may be limited depending on your

income. If you have both a Traditional and a Roth IRA, you may contribute to both,
but your combined contribution is limited.
8. An individual retirement
account for which
contributions are tax
Figure 11.9 "Differences between the Traditional and the Roth IRAs" is an
deductible and withdrawals are adaptation of a guide provided by the IRS to the key differences between a
taxed. Traditional and a Roth IRA.U.S. Department of the Treasury, Publication 590,
9. An individual retirement
Internal Revenue Service, 2009.
account for which
contributions are not
deductible but withdrawals are
not taxed.

Figure 11.9 Differences between the Traditional and the Roth IRAs
A rollover10 is a distribution of cash from one retirement fund to another. Funds

may be rolled into a Traditional IRA from an employer plan (401(k), 403b, or 457) or
from another IRA. You may not deduct a rollover contribution (since you have
already deducted it when it was originally contributed), but you are not taxed on
the distribution from one fund that you immediately contribute to another. A
transfer11 moves a retirement account, a Traditional IRA, from one trustee or asset
manager to another. Rollovers and transfers are not taxed if accomplished within
sixty days of distribution.
10. A retirement plan that may Self-Employed Individual Plans

accept or distribute funds from
another qualified retirement
account without tax
People who are self-employed wear many hats: employer, employee, and individual.
consequence or penalty. To accommodate them, there are several plans that allow for deductible
contributions.
11. The movement of funds in a
tax-advantaged retirement
account from one trustee or
A simplified employee pension (SEP)12 is a plan that allows an employer with few
asset manager to another that
is not considered a withdrawal or even no other employees than himself or herself to contribute deductible
or distribution of funds. retirement contributions to an employee’s Traditional IRA. Such an account is
called a SEP-IRA and is set up for each eligible employee. Contributions are limited:
12. A retirement plan for
employers with less than one in any year they can’t be more than 25 percent of salary or $46,000 (in 2008),
hundred employees or for the whichever is less. If you are self-employed and contributing to your own SEP-IRA,
self-employed, usually using the same limits apply, but you must also include any other contributions that you
individual IRAs (SEP-IRAs) as
retirement accounts.

have made to a qualified retirement plan.U.S. Department of the Treasury,

Publication 560, Internal Revenue Service, 2009.
A savings income match plan for employees (SIMPLE)13 is a plan where

employees make salary reduction (before tax) contributions that the employer
matches. If the contributions are made to a Traditional IRA, the plan is called a
SIMPLE IRA Plan. Any employer with fewer than one hundred employees who were
paid at least $5,000 in the preceding year may use a SIMPLE plan. There are also
SIMPLE 401(k) Plans. Deductible contributions are limited to $10,500 in 2008 for age
forty-nine and below, for example.U.S. Department of the Treasury, Publication 560,
A Keogh Plan14 is another retirement vehicle for small or self-employers. It can be

a defined benefit or a defined contribution qualified plan with deductible
contribution limits.
KEY TAKEAWAYS
• Retirement plans may be sponsored by employers, government, or

individuals.
• Defined benefit plans differ from defined contribution plans in that the
benefit is a specified amount for which the employer is liable. In a
defined contribution plan, the benefit is not specified, and the employee
is responsible for the accumulation in the plan.
• Social Security is an entitlement financed by payroll taxes and designed
to supplement employer retirement plans or individual retirement
plans.
• Traditional and Roth IRAs differ by the taxable nature of contributions
and withdrawals and by the age limits of contributions and withdrawals.
• Retirement plans for the self-employed are designed for those who are
both employee and employer.
13. A retirement plan for

employers with less than one
hundred employees or for the
self-employed.
14. A tax-advantaged retirement

plan for the self-employed.

EXERCISES
1. Do you participate in an employer-sponsored retirement savings plan? If

so, what kind of plan is it, and what do you see as the benefits and
drawbacks of participating? If you contribute to your plan, how did you
decide how much to contribute? Could you contribute more? In
searching for your next good job, what kind of retirement plan would
you prefer to find in the new employer’s benefit package, and why?
2. As part of your planning, how can you estimate what you can expect
from Social Security as a contribution to your retirement income? Find
this answer by going to http://www.ssa.gov/retire2. Using the menus at
this site, find out your retirement age. How many credits toward Social
Security do you have now? How many do you expect to accumulate over
your working life? Use one of the benefit calculators to find your
estimated Social Security benefit. How much could you receive monthly?
Would you be able to live on your Social Security alone? How much more
would you need to save for? What would happen if you continued to
work or went back to work after taking your retirement benefit? What
would happen if you took your benefit before your full retirement age?
3. Will your career path lead you to employment through government at
the local, state, or federal level (for example, in education, law
enforcement, or public health)? How are retirement plans for
government employees different from the plans described in this
section? Find answers to this question at http://www.opm.gov/RETIRE/.
4. What individual retirement account(s) do you have? Which type of IRA,
if any, would be best for you, and why? Why might it be a good idea to
have an IRA as a means of funding your retirement along with other
means? According to the Motley Fool article “All About IRAs” at
http://www.fool.com/Money/AllAboutIRAs/AllAboutIRAs.htm, what are
the chief advantages of IRAs? How many types of IRAs are there? Can
you withdraw money from an IRA account? What does AGI stand for, and
what is its significance for IRAs? When must you take a distribution
(cash out your IRA)?

11.3 Estate Planning
LEARNING OBJECTIVES
1. Identify the purposes, types, and components of a will.

2. Describe the roles and types of trusts and gifts.
3. Analyze the role of the estate tax in estate planning.
Your estate15 includes everything you own. Other aspects of financial planning
involve creating and managing your assets while you are alive. Estate planning is a
way to manage your assets after your death. Age is not really a factor, because
death can occur at any time, at any age, by any cause. Arranging for the disposition
of your estate is not a morbid concern but a kindness to those you leave behind.
Death is a legal and financial event—and in some cases a taxable event—as well as
an emotional one. Your loved ones will have to deal with the emotional aftermath
of your loss and will appreciate your care in planning for the legal and financial
outcomes of your death.
Wills
Since you won’t be here, you will need to leave a written document outlining your
instructions regarding your estate. That is your will16, your legal request for the
15. All real and personal property
distribution of your estate, that is, assets that remain after your debts have been
of a decedent at the time of
death, not including properties satisfied. If you die intestate17, or without a will, the laws of your state of legal
in joint ownership or assets residence will dictate the distribution of your estate.
that pass directly to a named
beneficiary.
You can write your own will so long as you are a legal adult and mentally
16. A legal document detailing the
disposition of assets upon competent. The document has to be witnessed by two or three people who are not
death. inheriting anything under the terms of the will, and it must be dated and signed
and, in some states, notarized. A holographic will18 is handwritten; it may be more
17. To die without a valid will,
leaving the disposition of difficult to validate. A statutory will19 is a preprinted will that you can buy from a
assets and debts to the law. store or in a software package. Consider, however, that a will is a legal document.
Having yours drawn up by a lawyer may better insure its completeness and validity
18. A handwritten or oral will.
in court.
19. A will written on a preprinted
form.
Probate20 is the legal process of validating a will and administering the payment of
20. The legal process of validating
debts and the distribution of assets by a probate court. Probate courts also
a will and overseeing the
orderly payment of debts and distribute property in the absence of a will. Probate is not required in every case,
the distribution of assets. however. Probate is not required if the deceased
352
• owned assets of little value, allowing for transfer without court

supervision;
• owned assets jointly with or “payable on death” to another person;
• owned assets naming another person as beneficiary;
• held all assets in a living trust (a legal entity for managing assets on
behalf of beneficiaries).
Besides the details of “who gets what,” a will should name an executor21, the
person or persons who will administer the payment of your debts and the
distribution of your remaining assets, according to your wishes as expressed in your
will. If you have legal dependents, your will should name a guardian for them. You
may also include a “letter of last instruction” stating the location of important
documents, safe deposit keys, and bank accounts and specifying your funeral
arrangements.
There are several types of wills. A simple will22 leaves everything to a spouse. For
comparatively small estates that are not taxable (e.g., estates with assets under a
million dollars in value), a simple will may be the most appropriate kind. A
traditional marital share will23 leaves one-half of the estate to a spouse and the
other half to others, usually children. This may lower any tax burden on your estate
and your spouse’s.
A stated dollar amount will24 allows you to leave

specific amounts to beneficiaries. A drawback of this Figure 11.10
type of will is that the stated amounts may be
reasonable when your will is drawn up but may not
reflect your intentions at the time of your death,
21. The person named in a will perhaps many years later. For that reason, rather than
who administers the payments
of debts and the distribution of
specifying specific amounts, it may be better to specify
assets, as described in the will. percentages of your asset values you would like each
beneficiary to have.
22. A will leaving all property to a
spouse. © 2010 Jupiterimages
Corporation
23. A will leaving one-half of the You may change or rewrite your will at any time, but
estate to the surviving spouse. you should definitely do so as your life circumstances
change, especially with events such as marriage or
24. A will leaving a specific
monetary amount to each divorce, the birth of a child, and the acquisition of
beneficiary. significant assets, such as a house. If the changes in your circumstances are
substantial, you should create a new will.
25. A document conveying your
intentions for your personal
care and management of your
It is possible that you will become mentally or physically disabled before you die
assets should you become
unable to do so before your and unable to direct management of your assets. To prepare for this possibility, you
death. may create a living will25 with instructions for your care in that event. You may
11.3 Estate Planning 353

appoint someone—usually a spouse, child, or sibling—who would have power of

attorney26, that is, the right to act on your behalf, especially as regards financial
and legal decisions. That power may be limited or unlimited (such as a “durable
power of attorney”) and is restricted to certain acts or dependent on certain
circumstances.
Along with granting power of attorney, your living will may include a health care
proxy, requesting that medical personnel follow the instructions of a designated
family member who expresses your wishes concerning your end-of-life treatment.
Many people request, for example, that they not be revived or sustained if they
cannot experience some quality of life. Be sure to update your living will, however,
as over time your views may change and as medical and technological advances
change our notions of “quality of life.”
Trusts and Gifts
A trust27 is a legal entity created by a trustor, or grantor, who owns assets managed
by a trustee or trustees for the benefit of a beneficiary or beneficiaries. A
testamentary trust28 may be established by a will so that beneficiaries who are
26. The legal right to act on your unable to manage assets (minor children or disabled dependents) can benefit from
behalf should you become
unable to do so before your the assets but have them managed for them. A living trust29 is established while
death. the grantor is alive. Unlike a will, it does not become a matter of public record upon
your death. A revocable living trust30 can be revoked by the grantor, who remains
27. A legal entity created to own
and manage assets for the the owner of the assets, at any time. Such a trust avoids the probate process but
benefit of beneficiaries. may not shield assets from estate taxes. An irrevocable living trust31 cannot be
changed; the grantor gives up ownership of his or her assets, which passes to the
28. A trust created by a will that
becomes effective upon the trust, avoiding probate and estate taxes. However, the trust then becomes a
death of the grantor. separate taxable entity and pays tax on its accumulated income.
29. A trust created while the
grantor is alive. Another way to avoid probate and estate taxes is to gift assets to your beneficiaries
30. A trust created while the while you are alive. Ownership of the assets passes to the beneficiaries at the time
grantor is living that may be of the gift, so the assets are no longer included in your estate. The federal
revoked or changed by the government and many state governments levy a gift tax for gifts exceeding certain
grantor; therefore, ownership
limits. In 2009, the annual exclusion from federal tax was $13,000 per recipient, for
of the grantor’s assets remains
under the control of the example. Also, the federal government does not tax gifts to spouses and to pay
grantor. others’ medical bills or tuitions.
31. A trust created while the
grantor is living, that may not There are limits to this kind of tax-free distribution of funds, however. For example,
be revoked or changed by the
grantor. The trust is the federal government considers any “gift” you make within three years prior to
considered a legal entity, and your death as part of your taxable estate. Gifting nevertheless is a way to reduce the
ownership of the grantor’s value of an estate. Some parents also prefer to make funds available or to gift them
assets is transferred to the
to their children when the children need them more—for example, earlier in their
trust.

adult lives when they may not have accrued enough wealth to make a down
payment on a house.
Most trusts, whether testamentary or living, revocable

or irrevocable, are created to avoid either the probate Figure 11.11
process or estate taxes or both. The probate process can
be long and costly and therefore a burden for your
executor, your beneficiaries (who may have to wait for
their distributions), and your estate.
Estate Taxes
Estate taxes diminish the value of your estate that will © 2010 Jupiterimages
be distributed to your beneficiaries. For that reason, one Corporation
of the purposes of estate planning is to try to minimize
those taxes.
The federal estate tax is “a tax on your right to transfer property at your
death.”U.S. Department of the Treasury, “Estate and Gift Taxes,” Internal Revenue
Service http://www.irs.gov (accessed May 3, 2009). In 2009, you are required to file
an estate tax return if the taxable estate is valued at $3,500,000 or more. In states
with estate taxes, you must file a return if the taxable estate value is more than
$1,000,000 or other similar cutoff amount. (For various philosophical and practical
reasons, the estate tax is the object of much political debate, so those filing limits
are subject to change.)
A taxable estate is the gross estate less allowable deductions. The tax law defines
the gross estate as the following:
• The value of all property in which you had an ownership interest at the
time of death
• Life insurance proceeds payable to your estate or, if you owned the
policy, to your heirs
• The value of certain annuities payable to your estate or your heirs
• The value of certain property you transferred within three years
before your deathU.S. Department of the Treasury, Publication 950,
Allowable deductions include debts that you owed at the time of death, including
mortgage debt, your funeral expenses, the value of property passing directly to
your surviving spouse (the marital deduction), charitable gifts, and the state estate

tax.U.S. Department of the Treasury, Publication 950, Internal Revenue Service,

2009.
Figure 11.12 "Estate Tax Filings in 2007" shows the scope of the estate tax in the U.S.
economy for 2007, the latest year for which data is available.
Figure 11.12 Estate Tax Filings in 2007
In the United States, with a total population of more than 306 million people, those
17,416 tax returns represent about 0.0057 percent of the population, paying about
0.9393 percent of the total taxes collected by the IRS in 2007.U.S. Department of the
Treasury, 2008, “SOI Tax Stats—IRS Data Book 2007,” Internal Revenue Service,
http://www.irs.gov/taxstats (accessed May 3, 2009).
While estate taxes tax your assets in your estate, inheritance taxes tax your assets
in the hands of your beneficiaries. Because of the costs involved, beneficiaries
potentially may not be able to afford to inherit or preserve wealth within the
family. For this reason and others, many states have redefined or repealed their
inheritance tax laws.
Estate taxes also can be more costly to beneficiaries if assets are not liquid—for
example, if a large portion of the value of your taxable estate is in your home or
business. Your survivors may be required to liquidate or sell assets just to pay the
estate taxes. To avoid that, some estate plans include purchasing a life insurance

policy for the anticipated amount of the estate tax, thus providing a source of liquid
funds or cash for tax payment.
Minimizing taxes owed is a goal of estate planning, but not the only goal. Your
primary objective is to see that your dependents are provided for by the
distribution of your assets and that your assets are distributed as you would wish
were you still there to distribute them yourself.
KEY TAKEAWAYS
• A will describes your wishes for the distribution of your assets (the
estate) after your death.
• Probate courts distribute assets in the absence of a will and administer
wills in estates with assets valued above a certain (variable) dollar
amount.
• There are many kinds of wills, including
◦ the simple will,

◦ the traditional marital share will,
◦ the stated dollar amount will.
• Living wills, with power of attorney and health care proxy, provide
medical directives, empower someone to manage your estate while you
are still alive, and authorize someone to make decision about your
health and end-of-life care.
• Trusts are used to provide the benefits of assets for beneficiaries
without them assuming responsibility for asset management.
• There are testamentary and living trusts, revocable and irrevocable
trusts. Setting up and administering trusts involves some considerable
expense.
• Creating trusts and giving gifts are ways to reduce the taxable value of
an estate.
• Estate planning should try to minimize the federal and state tax
obligations of estate disposition.

EXERCISES
1. What are the estate tax laws in your state? Does your state tax income
from Social Security payments? Does your state tax pensions and other
sources of retirement income? How does your state treat inheritance
taxes and estate taxes? What tax breaks does your state offer to retirees?
Find answers to these questions by visiting
http://www.retirementliving.com/taxes-by-state.
2. Draft a holographic will or use a form for a statutory will recognized in
your state. Start by reviewing your balance sheet, showing your assets,
liabilities, net worth, and inventory of personal and household property.
Think about how you would want your estate to be distributed upon
your death. Identify an executor. Sample the free forms and advice for
writing a will at http://www.free-legal- document.com/how-to-write-a-
will.html and http://www.alllaw.com/forms/wills_and_trusts/
last_will_and_testam/. Find out what kind of document your state
requires for a “last will and testament” at http://www.medlawplus.com/
library/legal/lastwillandtestamentform.htm. Also consider drafting a
living will. What should be in a living will? See http://www.alllaw.com/
articles/wills_and_trusts/article7.asp. What form for a living will does
your state recognize as legal (see http://liv-
will1.uslivingwillregistry.com/forms.html)? What is the purpose of the
U.S. Living Will Registry? According to the video clips on “How to Write
Your Own Will” by lawyers at http://resources.lawinfo.com/en/Videos/
Wills/Federal/how-write-your-own-will.html, why and when should you
have a lawyer draw up your will or review a will you have written
yourself?
3. Survey information about living trusts (also called life estates in some
states) at NOLO.com at http://www.nolo.com/info/living-trust. When
and why might you want to create a living trust as an alternative to a
will? See http://www.investopedia.com/articles/pf/06/
revocablelivingtrust.asp. According to the National Consumer Law
Center, what questions should you ask to avoid becoming a victim of
living trust scams? See http://www.nclc.org/images/pdf/
older_consumers/consumer_concerns/
cc_avoiding_living_trust_scams.pdf.

Chapter 12
Investing
Introduction
Saving to build wealth is investing. When people have too much money to spend
immediately, that is, a surplus of disposable income, they become savers or
investors. They transfer their surplus to individuals, companies, or governments
that have a shortage or too little money to meet immediate needs. This is almost
always done through an intermediary—a bank or broker—who can match up the
surpluses and the shortages. If the capital markets work well, those who need
money can get it, and those who can defer their need can try to profit from that.
When you invest, you are transferring capital to those who need it on the
assumption that they will be able to return your capital when you need or want it
and that they will also pay you for its use in the meantime.
Investing happens over your lifetime. In your early adult years, you typically have
little surplus to invest. Your first investments are in your home (although primarily
financed with the debt of your mortgage) and then perhaps in planning for
children’s education or for your retirement.
After a period of just paying the bills, making the

mortgage, and trying to put something away for Figure 12.1
retirement, you may have the chance to accumulate
wealth. Your income increases as your career
progresses. You have fewer dependents (as children
leave home), so your expenses decrease. You begin to
think about your investment options. You have already
been investing—in your home and retirement—but
those investments have been prescribed by their
specific goals. © 2010 Jupiterimages
Corporation
You may reach this stage earlier or later in your life, but
at some point, you begin to think beyond your
immediate situation and look to increase your real
wealth and to your future financial health. Investing is about that future.
359
Chapter 12 Investing
12.1 Investments and Markets: A Brief Overview
LEARNING OBJECTIVES
1. Identify the features and uses of issuing, owning, and trading bonds.
2. Identify the uses of issuing, owning, and trading stocks.
3. Identify the features and uses of issuing, owning, and trading
commodities and derivatives.
4. Identify the features and uses of issuing, owning, and trading mutual
funds, including exchange-traded funds and index funds.
5. Describe the reasons for different instruments in different markets.
Before looking at investment planning and strategy, it is important to take a closer

look at the galaxy of investments and markets where investing takes place.
Understanding how markets work, how different investments work, and how
different investors can use investments is critical to understanding how to begin to
plan your investment goals and strategies.
You have looked at using the money markets to save surplus cash for the short
term. Investing is primarily about using the capital markets to invest surplus cash
for the longer term. As in the money markets, when you invest in the capital
markets, you are selling liquidity.
The capital markets developed as a way for buyers to buy liquidity. In Western
Europe, where many of our ideas of modern finance began, those early buyers were
usually monarchs or members of the nobility, raising capital to finance armies and
navies to conquer or defend territories or resources. Many devices and markets
were used to raise capital,For a thorough history of the evolution of finance and
financial instruments, see Charles P. Kindleberger, A Financial History of Western
Europe (London: George Allen & Unwin, Ltd., 1984). but the two primary methods
that have evolved into modern times are the bond and stock markets. (Both are
discussed in greater detail in Chapter 15 "Owning Stocks" and Chapter 16 "Owning
Bonds", but a brief introduction is provided here to give you the basic idea of what
they are and how they can be used as investments.)
In the United States, 47 percent of the adult population owns stocks or bonds, most
through retirement accounts.John Sabelhaus, Michael Bogdan, and Daniel Schrass,
“Equity and Bond Ownership in America, 2008,” Investment Company Institute and
360
Securities Industry and Financial Markets Association, http://www.ici.org/pdf/

rpt_08_equity_owners.pdf (accessed on May 20, 2009).
Figure 12.2 Amsterdam Stock Exchange
The Amsterdam Stock Exchange was established in 1602 by the Dutch East India Company, the first company in the
world to issue stock and trade publicly. The company paid 18 percent annually for nearly two hundred years, based
on its near monopoly of the Indonesian spice trade. Competition and corruption ended the exchange, which went
bankrupt in 1798.
© Amsterdam Municipal Department for the Preservation and Restoration of Historic Buildings and Sites; used by
permission.
Bonds and Bond Markets
Bonds1 are debt. The bond issuer borrows by selling a bond, promising the buyer
regular interest payments and then repayment of the principal at maturity. If a
company wants to borrow, it could just go to one lender and borrow. But if the
company wants to borrow a lot, it may be difficult to find any one investor with the
capital and the inclination to make large a loan, taking a large risk on only one
borrower. In this case the company may need to find a lot of lenders who will each
1. Publicly issued and traded lend a little money, and this is done through selling bonds.
long-term debt used by
corporations and governments.
12.1 Investments and Markets: A Brief Overview 361

A bond is a formal contract to repay borrowed money with interest (often referred
to as the coupon) at fixed intervals. Corporations and governments (e.g., federal,
state, municipal, and foreign) borrow by issuing bonds. The interest rate on the
bond may be a fixed interest rate2 or a floating interest rate3 that changes as
underlying interest rates—rates on debt of comparable companies—change.
(Underlying interest rates include the prime rate that banks charge their most
trustworthy borrowers and the target rates set by the Federal Reserve Bank.)
There are many features of bonds other than the principal and interest, such as the
issue price4 (the price you pay to buy the bond when it is first issued) and the
maturity date5 (when the issuer of the bond has to repay you). Bonds may also be
“callable”: redeemable6 before maturity7 (paid off early). Bonds may also be issued
with various covenants8 or conditions that the borrower must meet to protect the
bondholders, the lenders. For example, the borrower, the bond issuer, may be
required to keep a certain level of cash on hand, relative to its short-term debts, or
2. A bond interest rate that does may not be allowed to issue more debt until this bond is paid off.
not change over time, from
issuance to maturity.
Because of the diversity and flexibility of bond features, the bond markets are not
3. A bond interest rate that
changes over time, usually as transparent as the stock markets; that is, the relationship between the bond and
related to a benchmark rate its price is harder to determine. The U.S. bond market is now more than twice the
such as the U.S. discount rate size (in dollars of capitalization) of all the U.S. stock exchanges combined, with debt
or prime rate.
of more than $27 trillion by the end of 2007.Financial Industry Regulatory Authority
4. The original market price of a (FINRA), http://apps.finra.org/ (accessed May 20, 2009).
bond at issuance.
5. Date at which a bond matures, U.S. Treasury bonds are auctioned regularly to banks and large institutional
or the end of the bond’s term,
when the bond must be
investors by the Treasury Department, but individuals can buy U.S. Treasury bonds
redeemed. directly from the U.S. government (http://www.treasurydirect.gov). To trade any
other kind of bond, you have to go through a broker. The brokerage firm acts as a
6. A bond that is eligible for
redemption.
principal or dealer, buying from or selling to investors, or as an agent for another
buyer or seller.
7. The date on which payment of
a financial obligation is due,
such as bond redemption date. Stocks and Stock Markets
8. A condition placed on bond
issuers (borrowers) to protect Stocks9 or equity securities are shares of ownership. When you buy a share of stock,
bondholders (lenders). you buy a share of the corporation. The size of your share of the corporation is
9. Shares issued to account for proportional to the size of your stock holding. Since corporations exist to create
ownership, as defined by profit for the owners, when you buy a share of the corporation, you buy a share of
owners’ contributions to a its future profits. You are literally sharing in the fortunes of the company.
corporation.
10. A share of corporate profit

distributed to shareholders,
Unlike bonds, however, shares do not promise you any returns at all. If the
usually as cash or corporate company does create a profit, some of that profit may be paid out to owners as a
stock. dividend10, usually in cash but sometimes in additional shares of stock. The

company may pay no dividend at all, however, in which case the value of your
shares should rise as the company’s profits rise. But even if the company is
profitable, the value of its shares may not rise, for a variety of reasons having to do
more with the markets or the larger economy than with the company itself.
Likewise, when you invest in stocks, you share the company’s losses, which may
decrease the value of your shares.
Corporations issue shares to raise capital. When shares are issued and traded in a
public market such as a stock exchange11, the corporation is “publicly traded.”
There are many stock exchanges in the United States and around the world. The
two best known in the United States are the New York Stock Exchange (now NYSE
Euronext), founded in 1792, and the NASDAQ, a computerized trading system
managed by the National Association of Securities Dealers (the “AQ” stands for
“Automated Quotations”).
Only members of an exchange may trade on the exchange, so to buy or sell stocks
you must go through a broker who is a member of the exchange. Brokers also
manage your account and offer varying levels of advice and access to research. Most
brokers have Web-based trading systems. Some discount brokers offer minimal
advice and research along with minimal trading commissions and fees.
11. An organized market for the

trading of corporate shares
conducted by members of the
exchange.

Figure 12.3 Shanghai Stock Exchange, China
The Shanghai Stock Exchange (SSE), one of three exchanges in China, is not open to foreign investors. It is the sixth
largest stock exchange in the world. The other exchanges in China are the Shenzhen Stock Exchange (SZSE) and the
Hong Kong Stock Exchange (HKE). The Hang Seng is an index of Asian stocks on the HKE that is popular with
investors interested in investing in Asian companies.
© Baycrest Gallery, used by permission
Commodities and Derivatives
Commodities12 are resources or raw materials, including the following:
• Agricultural products (food and fibers), such as soybeans, pork bellies,

and cotton
• Energy resources such as oil, coal, and natural gas
• Precious metals such as gold, silver, and copper
• Currencies, such as the dollar, yen, and euro
12. Raw materials—natural
resources or agricultural
products—used as inputs in
processing goods and services.

Commodity trading was formalized because of the risks inherent in producing

commodities—raising and harvesting agricultural products or natural
resources—and the resulting volatility of commodity prices. As farming and food
production became mechanized and required a larger investment of capital,
commodity producers and users wanted a way to reduce volatility by locking in
prices over the longer term.
The answer was futures and forward contracts. Futures13 and forward contracts14
or forwards are a form of derivatives15, the term for any financial instrument
whose value is derived from the value of another security. For example, suppose it
is now July 2010. If you know that you will want to have wheat in May of 2011, you
could wait until May 2011 and buy the wheat at the market price, which is unknown
in July 2010. Or you could buy it now, paying today’s price, and store the wheat until
May 2011. Doing so would remove your future price uncertainty, but you would
incur the cost of storing the wheat.
Alternatively, you could buy a futures contract for May 2011 wheat in July 2010. You
would be buying May 2011 wheat at a price that is now known to you (as stated in
the futures contract), but you will not take delivery of the wheat until May 2011.
The value of the futures contract to you is that you are removing the future price
uncertainty without incurring any storage costs. In July 2010 the value of a contract
to buy May 2011 wheat depends on what the price of wheat actually turns out to be
in May 2011.
Forward contracts are traded privately, as a direct deal made between the seller and
13. A publicly traded contract to the buyer, while futures contracts are traded publicly on an exchange such as the
buy or sell an asset at a Chicago Mercantile Exchange (CME) or the New York Mercantile Exchange
specified time and price in the
(NYMEX).
future.
14. A private contract to buy or

sell an asset at a specified time When you buy a forward contract for wheat, for example, you are literally buying
and price in the future. future wheat, wheat that doesn’t yet exist. Buying it now, you avoid any uncertainty
about the price, which may change. Likewise, by writing a contract to sell future
15. Financial instruments such as
options, futures, forwards, wheat, you lock in a price for your crop or a return for your investment in seed and
securitized assets, and so on fertilizer.
whose value is derived from
the value of another asset.
Futures and forward contracts proved so successful in shielding against some risk
16. The right but not the
obligation to buy or sell at a that they are now written for many more types of “commodities,” such as interest
specific price at a specific time rates and stock market indices. More kinds of derivatives have been created as well,
in the future; commonly such as options. Options16 are the right but not the obligation to buy or sell at a
written on shares of stock as
specific price at a specific time in the future. Options are commonly written on
well as on stock indices,
interest rates, and shares of stock as well as on stock indices, interest rates, and commodities.
commodities.

Derivatives such as forwards, futures, and options are used to hedge or protect
against an existing risk or to speculate on a future price. For a number of reasons,
commodities and derivatives are more risky than investing in stocks and bonds and
are not the best choice for most individual investors.
Mutual Funds, Index Funds, and Exchange-Traded Funds
A mutual fund17 is an investment portfolio consisting of securities that an

individual investor can invest in all at once without having to buy each investment
individually. The fund thus allows you to own the performance of many
investments while actually buying—and paying the transaction cost for
buying—only one investment.
Mutual funds have become popular because they can provide diverse investments
with a minimum of transaction costs. In theory, they also provide good returns
through the performance of professional portfolio managers.
An index fund18 is a mutual fund designed to mimic the performance of an index, a

particular collection of stocks or bonds whose performance is tracked as an
indicator of the performance of an entire class or type of security. For example, the
Standard & Poor’s (S&P) 500 is an index of the five hundred largest publicly traded
corporations, and the famous Dow Jones Industrial Average is an index of thirty
17. A portfolio of investments stocks of major industrial corporations. An index fund is a mutual fund invested in
created by an investment
the same securities as the index and so requires minimal management and should
company such as a brokerage
or bank. It is financed as the have minimal management fees or costs.
investment company sells
shares of the fund to investors.
For investors, a mutual fund Mutual funds are created and managed by mutual fund companies or by brokerages
provides a way to achieve or even banks. To trade shares of a mutual fund you must have an account with the
maximum diversification with
company, brokerage, or bank. Mutual funds are a large component of individual
minimal transaction costs
through economies of scale. retirement accounts and of defined contribution plans.
18. A mutual fund designed to

track the performance of an Mutual fund shares are valued at the close of trading each day and orders placed
index for investors who seek the next day are executed at that price until it closes. An exchange-traded fund
diversification without having
to select securities. (ETF)19 is a mutual fund that trades like a share of stock in that it is valued
continuously throughout the day, and trades are executed at the market price.
19. A fund that tracks an index or
a commodity or a basket of
assets but is traded like stocks The ways that capital can be bought and sold is limited only by the imagination.
on a stock exchange.
When corporations or governments need financing, they invent ways to entice
20. The use of mathematical investors and promise them a return. The last thirty years has seen an explosion in
modeling to create and value financial engineering20, the innovation of new financial instruments through
new financial instruments and
mathematical pricing models. This explosion has coincided with the ever-
markets.

expanding powers of the computer, allowing professional investors to run the

millions of calculations involved in sophisticated pricing models. The Internet also
gives amateurs instantaneous access to information and accounts.
Much of the modern portfolio theory that spawned these innovations (i.e., the idea
of using the predictability of returns to manage portfolios of investments) is based
on an infinite time horizon, looking at performance over very long periods of time.
This has been very valuable for institutional investors (e.g., pension funds,
insurance companies, endowments, foundations, and trusts) as it gives them the
chance to magnify returns over their infinite horizons.
For most individual investors, however, most portfolio

theory may present too much risk or just be impractical. Figure 12.4
Individual investors don’t have an infinite time horizon.
You have only a comparatively small amount of time to
create wealth and to enjoy it. For individual investors,
investing is a process of balancing the demands and
desires of returns with the costs of risk, before time
runs out.
Corporation

KEY TAKEAWAYS
• Bonds are
◦ a way to raise capital through borrowing, used by

corporations and governments;
◦ an investment for the bondholder that creates return
through regular, fixed or floating interest payments on the
debt and the repayment of principal at maturity;
◦ traded on bond exchanges through brokers.
• Stocks are
◦ a way to raise capital through selling ownership or equity;

◦ an investment for shareholders that creates return through
the distribution of corporate profits as dividends or through
gains (losses) in corporate value;
◦ traded on stock exchanges through member brokers.
• Commodities are
◦ natural or cultivated resources;

◦ traded to hedge revenue or production needs or to speculate
on resources’ prices;
◦ traded on commodities exchanges through brokers.
• Derivatives are instruments based on the future, and therefore
uncertain, price of another security, such as a share of stock, a
government bond, a currency, or a commodity.
• Mutual funds are portfolios of investments designed to achieve

maximum diversification with minimal cost through economies
of scale.
◦ An index fund is a mutual fund designed to replicate the

performance of an asset class or selection of investments
listed on an index.
◦ An exchange-traded fund is a mutual fund whose shares are
traded on an exchange.

• Institutional and individual investors differ in the use of different

investment instruments and in using them to create appropriate
portfolios.

EXERCISES
1. In My Notes or your personal finance journal, record your experiences

with investing. What investments have you made, and how much do you
have invested? What stocks, bonds, funds, or other instruments,
described in this section, do you have now (or had in the past)? How
were the decisions about your investments made, and who made them?
If you have had no personal experience with investing, explain your
reasons. What reasons might you have for investing (or not) in the
future?
2. About how many stock exchanges exist in the world? Which geographic
region has the greatest number of exchanges? Sample features of stock
exchanges on each continent at http://www.tdd.lt/slnews/
Stock_Exchanges/Stock.Exchanges.htm. What characteristics do all the
exchanges share?
3. What is a brokerage house, and when would you use a broker? Find out
at http://www.wisegeek.com/what-is-a-brokerage-house.htm. Sample
brokerage houses that advertise online. What basic products and
services do all brokerages offer? According to the advice at
http://gti.cuna.org/18592/worksheets/evaluate_broker.pdf, what is the
best way to choose a broker? Discuss brokers with classmates to develop
a list of ten questions you would want to ask a broker before you opened
an account. (Hint: Search the Motley Fool’s 2009 “Brokerage Questions
for Beginners” at http://www.fool.com.)
4. Visit the Chicago Mercantile Exchange at http://www.cmegroup.com/.
What are some examples of commodities on the CME that theoretically
could be part of your investment portfolio? In what energy product does
the CME specialize? Could you invest in whether a foreign currency will
rise or fall in relation to another currency? Could you invest in whether
interest rates will rise or fall? Could you invest in how the weather will
change?
5. An example of financial engineering is the derivative known as the
credit default swap, a form of insurance against defaults on underlying
financial instruments—for example, paying out on defaults on loan
payments. According to Senator Harkin’s (D-Iowa) 2009 report at
http://www.iowapolitics.com/index.iml?Article=160768, why must
derivatives like credit default swaps and their markets be more
rigorously regulated? Regulation is a perennial political issue. What are
some arguments for and against the regulation or deregulation of the
capital markets? What are the implications of regulation and
deregulation for investors?

12.2 Investment Planning
LEARNING OBJECTIVES
1. Describe the advantages of the investment policy statement as a useful

framework for investment planning.
2. Identify the process of defining investor return objectives.
3. Identify the process of defining investor risk tolerance.
4. Identify investor constraints or restrictions on an investment strategy.
Allison has a few hours to kill while her flight home is

delayed. She loves her job as an analyst for a Figure 12.5
management consulting firm, but the travel is getting
old. As she gazes at the many investment magazines and
paperbacks on display and the several screens all tuned
to financial news networks and watches people
hurriedly checking their stocks on their mobile phones,
she begins to think about her own investments. She has
been paying her bills, paying back student loans and
trying to save some money for a while. Her uncle just © 2010 Jupiterimages
died and left her a bequest of $50,000. She is thinking of Corporation
investing it since she is getting by on her salary and has
no immediate plans for this windfall.
Allison is wondering how to get into some serious investing. She is thinking that
since so many people seem to be interested in “Wall Street,” there must be money
in it. There is no lack of information or advice about investing, but Allison isn’t sure
how to get started.
Allison may not realize that there are as many different investment strategies as
there are investors. The planning process is similar to planning a budget plan or
savings plan. You figure out where you are, where you want to be, and how to get
there. One way to get started is to draw up an individual investment policy
statement.
21. A structured framework for Investment policy statements21, outlines of the investor’s goals and constraints,
investment planning based on are popular with institutional investors such as pension plans, insurance
the investor’s return
objectives, risk tolerance, and companies, or nonprofit endowments. Institutional investment decisions typically
constraints. are made by professional managers operating on instructions from a higher
371
authority, usually a board of directors or trustees. The directors or trustees may

approve the investment policy statement and then leave the specific investment
decisions up to the professional investment managers. The managers use the policy
statement as their guide to the directors’ wishes and concerns.
This idea of a policy statement has been adapted for individual use, providing a
helpful, structured framework for investment planning—and thinking. The
advantages of drawing up an investment policy to use as a planning framework
include the following:
• The process of creating the policy requires thinking through your goals
and expectations and adjusting those to what is possible.
• The policy statement gives you an active role in your investment
planning, even if the more specific details and implementation are left
to a professional investment advisor.
• Your policy statement is portable, so even if you change advisors, your
plan can go with you.
• Your policy statement is flexible; it can and should be updated at least
once a year.
A policy statement is written in two parts. The first part lists your return objectives
and risk preferences as an investor. The second part lists your constraints on
investment. It sometimes is difficult to reconcile the two parts. That is, you may
need to adjust your statement to improve your chances of achieving your return
objectives within your risk preferences without violating your constraints.
Defining Return Objective and Risk
Defining return objectives is the process of quantifying the required annual return
(e.g., 5 percent, 10 percent) necessary to meet your investment goals. If your
investment goals are vague (e.g., to “increase wealth”), then any positive return will
do. Usually, however, you have some specific goals—for example, to finance a
child’s or grandchild’s education, to have a certain amount of wealth at retirement,
to buy a sailboat on your fiftieth birthday, and so on.
Once you have defined goals, you must determine when they will happen and how
much they will cost, or how much you will have to have invested to make your
dreams come true. As explained in Chapter 4 "Evaluating Choices: Time, Risk, and
Value", the rate of return that your investments must achieve to reach your goals
depends on how much you have to invest to start with, how long you have to invest
it, and how much you need to fulfill your goals.
12.2 Investment Planning 372

As in Allison’s case, your goals may not be so specific.

Your thinking may be more along the lines of “I want Figure 12.6
my money to grow and not lose value” or “I want the
investment to provide a little extra spending money
until my salary rises as my career advances.” In that
case, your return objective can be calculated based on
the role that these funds play in your life: safety net,
emergency fund, extra spending money, or nest egg for
the future.
Corporation
However specific (or not) your goals may be, the
quantified return objective defines the annual
performance that you demand from your investments.
Your portfolio can then be structured—you can choose
your investments—such that it can be expected to provide that performance.
If your return objective is more than can be achieved given your investment and
expected market conditions, then you know to scale down your goals, or perhaps
find a different way to fund them. For example, if Allison wanted to stop working in
ten years and start her own business, she probably would not be able to achieve this
goal solely by investing her $50,000 inheritance, even in a bull (up) market earning
higher rates of return.
As you saw in Chapter 10 "Personal Risk Management: Insurance" and Chapter 11

"Personal Risk Management: Retirement and Estate Planning", in investing there is
a direct relationship between risk and return, and risk is costly. The nature of these
relationships has fascinated and frustrated investors since the origin of capital
markets and remains a subject of investigation, exploration, and debate. To invest is
to take risk. To invest is to separate yourself from your money through actual
distance—you literally give it to someone else—or through time. There is always
some risk that what you get back is worth less (or costs more) than what you
invested (a loss) or less than what you might have had if you had done something
else with your money (opportunity cost). The more risk you are willing to take, the
more potential return you can make, but the higher the risk, the more potential
losses and opportunity costs you may incur.
Individuals have different risk tolerances. Your risk tolerance22 is your ability and
willingness to assume risk. Your ability to assume risk is based on your asset base,
your time horizon, and your liquidity needs. In other words, your ability to take
investment risks is limited by how much you have to invest, how long you have to
22. An investor’s capacity for risk invest it, and your need for your portfolio to provide cash—for use rather than
exposure, based on the ability
reinvestment—in the meantime.
and willingness to assume risk.

Your willingness to take risk is shaped by your “personality,” your experiences, and
your knowledge and education. Attitudes are shaped by life experiences, and
attitudes toward risk are no different. Figure 12.7 "Risk Tolerance" shows how your
level of risk tolerance develops.
Figure 12.7 Risk Tolerance
Investment advisors may try to gauge your attitude toward risk by having you
answer a series of questions on a formal questionnaire or by just talking with you
about your investment approach. For example, an investor who says, “It’s more
important to me to preserve what I have than to make big gains in the markets,” is
relatively risk averse23. The investor who says, “I just want to make a quick profit,”
is probably more of a risk seeker.
Once you have determined your return objective and risk tolerance (i.e., what it will
take to reach your goals and what you are willing and able to risk to get there) you
may have to reconcile the two. You may find that your goals are not realistic unless
you are willing to take on more risk. If you are unwilling or unable to take on more
risk, you may have to scale down your goals.
23. An investor’s preference to
minimize exposure to risk.

Defining Constraints
Defining constraints is a process of recognizing any limitation that may impede or

slow or divert progress toward your goals. The more you can anticipate and include
constraints in your planning, the less likely they will throw you off course.
Constraints include the following:
• Liquidity needs
• Time available
• Tax obligations
• Legal requirements
• Unique circumstances
Liquidity needs, or the need to use cash, can slow your progress from investing
because you have to divert cash from your investment portfolio in order to spend it.
In addition you will have ongoing expenses from investing. For example, you will
have to use some liquidity to cover your transaction costs such as brokerage fees
and management fees. You may also wish to use your portfolio as a source of
regular income or to finance asset purchases, such as the down payment on a home
or a new car or new appliances.
While these may be happy transactions for you, for your portfolio they are negative
events, because they take away value from your investment portfolio. Since your
portfolio’s ability to earn return is based on its value, whenever you take away from
that value, you are reducing its ability to earn.
Time is another determinant of your portfolio’s earning power. The more time you
have to let your investments earn, the more earnings you can amass. Or, the more
time you have to reach your goals, the more slowly you can afford to get there,
earning less return each year but taking less risk as you do. Your time horizon will
depend on your age and life stage and on your goals and their specific liquidity
needs.
Tax obligations are another constraint, because paying taxes takes value away from
your investments. Investment value may be taxed in many ways (as income tax,
capital gains tax, property tax, estate tax, or gift tax) depending on how it is
invested, how its returns are earned, and how ownership is transferred if it is
bought or sold.
Investors typically want to avoid, defer, or minimize paying taxes, and some
investment strategies will do that better than others. In any case, your individual

tax liabilities may become a constraint in determining how the portfolio earns to
best avoid, defer, or minimize taxes.
Legalities also can be a constraint if the portfolio is not owned by you as an

individual investor but by a personal trust or a family foundation. Trusts and
foundations have legal constraints defined by their structure.
“Unique circumstances” refer to your individual preferences, beliefs, and values as

an investor. For example, some investors believe in socially responsible investing
(SRI), so they want their funds to be invested in companies that practice good
corporate governance, responsible citizenship, fair trade practices, or
environmental stewardship.
Some investors don’t want to finance companies that make objectionable products
or by-products or have labor or trade practices reflecting objectionable political
views. Divestment24 is the term for taking money out of investments. Grassroots
political movements often include divestiture campaigns, such as student demands
that their universities stop investing in companies that do business with
nondemocratic or oppressive governments.
Socially responsible investment25 is the term for investments based on ideas

about products or businesses that are desirable or objectionable. These qualities are
in the eye of the beholder, however, and vary among investors. Your beliefs and
values are unique to you and to your circumstances in investing and may change
over time.
Having mapped out your goals and determined the risks you are willing to take, and
having recognized the limitations you must work with, you and/or investment
advisors can now choose the best investments. Different advisors may have
different suggestions based on your investment policy statement. The process of
choosing involves knowing what returns and risks investments have produced in
the past, what returns and risks they are likely to have in the future, and how the
returns and risks are related—or not—to each other.
24. The sale of an asset to reverse

an invested position.
25. An investment strategy to

achieve both ethical and
financial goals.

KEY TAKEAWAYS
• The investment policy statement provides a useful framework

for investment planning because
◦ the process of creating the policy requires thinking through

goals and expectations and adjusting those to the possible;
◦ the statement gives the investor an active role in investment
planning, even if the more specific details and
implementation are left to a professional investment advisor;
◦ the statement is portable, so that even if you change advisors
your plans can go with you;
◦ the statement is flexible; it can and should be updated at
least once per year.
• Return objectives are defined by the investor’s goals, time horizon, and
value of the asset base.
• Risk tolerance is defined by the investor’s ability and willingness to
assume risk; comfort with risk taking relates to personality, experience,
and knowledge.
• Constraints or restrictions to an investment strategy are the

investor’s
◦ liquidity needs,
◦ time horizon,
◦ tax circumstances and obligations,
◦ legal restrictions,
◦ unique preferences or circumstances.
• Social investment and divestment are unique preferences based on
beliefs and values about desirable or objectionable industries, products,
or companies.
• Your investment policy statement guides the selection of investments
and development of your investment portfolio.

EXERCISES
1. Brainstorm with classmates expressions or homilies relating to

investing, such as you gotta pay to play; you gotta play to win; no pain, no
gain; it takes money to make money; and so on. What does each of these
expressions really mean? How do they relate to the concepts of
investment risk and return on investment? In what ways are risks and
returns in a reciprocal relationship?
2. Draft an individual investment policy statement as a guide to your
future investment planning. What will be the advantages of having an
investment policy statement? In My Notes or your personal finance
journal, record your general return objectives and specific goals at this
time. What is a return objective?
3. What is your level of risk tolerance? How would you rate your risk
tolerance on a five-point scale (with one indicating “most risk averse”)?
In your personal finance journal, record how your asset base, time
horizon, and liquidity needs define your ability to undertake investment
risk. Then describe the personality characteristics, past experiences, and
knowledge base that you feel help shape your degree of willingness to
undertake risk. Now check your beliefs by taking the Risk Tolerance
Quiz at http://www.isi-su.com/new/risktol2.htm. How do the results
compare with your estimate? Compare the results with the Risk
Tolerance Questionnaire at Kiplinger’s (http://www.kiplinger.com/
tools/riskfind.html) and other tests of risk tolerance offered on
commercial Web sites. What conclusions do you draw from these tests?
What percent of your investments do you now think you could put into
stocks? What factor could you change that might enable you to tolerate
more risk?
4. In My Notes or your personal finance journal, record the constraints you
face against reaching your investment goals. With what types of
constraints must you reconcile your investment planning? The more
you need to use your money to live and the less time you have to achieve
your goals, the greater the constraints in your investment planning.
Revise your statement of goals and return objectives as needed to ensure
it is realistic in light of your constraints.
5. In collaboration with classmates, conduct an online investigation

into socially responsible investing. See the following Web sites:
◦ http://www.socialinvest.org
◦ http://www.greeninvestment.com

◦ http://www.newsreview.com/sacramento/
content?oid=323855
◦ http://online.wsj.com/article/SB118239582814643063.html
◦ http://www.nolo.com/article.cfm/ObjectID/8E5E996A-
B251-41C1-B1F867B8EB112ED3/catID/498F840B-0B7B-4A9A-
AE102EC156E16660/104/284/164/ART
On the basis of your investigation, outline and discuss the

different forms and purposes of SRI. Which form and purpose
appeal most to you and why? What investments might you make,
and what investments might you specifically avoid, to express
your beliefs and values? Do you think investment planning could
ever have a role in bringing about social change?

12.3 Measuring Return and Risk
LEARNING OBJECTIVES
1. Characterize the relationship between risk and return.

2. Describe the differences between actual and expected returns.
3. Explain how actual and expected returns are calculated.
4. Define investment risk and explain how it is measured.
5. Define the different kinds of investment risk.
You want to choose investments that will combine to achieve the return objectives
and level of risk that’s right for you, but how do you know what the right
combination will be? You can’t predict the future, but you can make an educated
guess based on an investment’s past history. To do this, you need to know how to
read or use the information available. Perhaps the most critical information to have
about an investment is its potential return and susceptibility to types of risk.
Return
Returns are always calculated as annual rates of return, or the percentage of return
created for each unit (dollar) of original value. If an investment earns 5 percent, for
example, that means that for every $100 invested, you would earn $5 per year
(because $5 = 5% of $100).
Returns are created in two ways: the investment creates income or the investment
gains (or loses) value. To calculate the annual rate of return for an investment, you
need to know the income created, the gain (loss) in value, and the original value at
the beginning of the year. The percentage return can be calculated as in Figure 12.8
"Calculating Percentage Return".
Figure 12.8 Calculating Percentage Return
380
Note that if the ending value is greater than the original value, then Ending value −
Original value > 0 (is greater than zero), and you have a gain that adds to your
return. If the ending value is less, then Ending value − Original value < 0 (is less than
zero), and you have a loss that detracts from your return. If there is no gain or loss,
if Ending value − Original value = 0 (is the same), then your return is simply the
income that the investment created.
For example, if you buy a share of stock for $100, and it pays no dividend, and a year
later the market price is $105, then your return = [0 + (105 − 100)] ÷ 100 = 5 ÷ 100 =
5%. If the same stock paid a dividend of $2, then your return = [2 + (105 − 100)] ÷ 100
= 7 ÷ 100 = 7%.
If the information you have shows more than one year’s results, you can calculate
the annual return using what you learned in Chapter 4 "Evaluating Choices: Time,
Risk, and Value" about the relationships of time and value. For example, if an
investment was worth $10,000 five years ago and is worth $14,026 today, then
$10,000 × (1+ r)5 = $14,026. Solving for r—the annual rate of return, assuming you
have not taken the returns out in the meantime—and using a calculator, a computer
application, or doing the math, you get 7 percent. So the $10,000 investment must
have earned at a rate of 7 percent per year to be worth $14,026 five years later,
other factors being equal.
While information about current and past returns is useful, investment

professionals are more concerned with the expected return26 for the investment,
that is, how much it may be expected to earn in the future. Estimating the expected
return is complicated because many factors (i.e., current economic conditions,
industry conditions, and market conditions) may affect that estimate.
For investments with a long history, a strong indicator of future performance may
be past performance. Economic cycles fluctuate, and industry and firm conditions
vary, but over the long run, an investment that has survived has weathered all
those storms. So you could look at the average of the returns for each year. There
are several ways to do the math, but if you look at the average return for different
investments of the same asset class or type (e.g., stocks of large companies) you
could compare what they have returned, on average, over time. Figure 12.9 "S&P
500 Average Annual Return" shows average returns on investments in the S&P 500,
an index of large U.S. companies since 1990.
26. The return expected for an
investment based on its
average historical
performance. Statistically, it is
the mean or average of the
investment’s past
performance.
12.3 Measuring Return and Risk 381

Figure 12.9 S&P 500 Average Annual ReturnBased on data from Standard & Poor’s, Inc.,
http://www2.standardandpoors.com/spf/xls/index/MONTHLY.xls (accessed November 24, 2009).
If the time period you are looking at is long enough, you can reasonably assume
that an investment’s average return over time is the return you can expect in the
next year. For example, if a company’s stock has returned, on average, 9 percent
per year over the last twenty years, then if next year is an average year, that
investment should return 9 percent again. Over the eighteen-year span from 1990
to 2008, for example, the average return for the S&P 500 was 9.16 percent. Unless
you have some reason to believe that next year will not be an average year, the
average return can be your expected return. The longer the time period you
consider, the less volatility there will be in the returns, and the more accurate your
prediction of expected returns will be.
Returns are the value created by an investment, through either income or gains.
Returns are also your compensation for investing, for taking on some or all of the
risk of the investment, whether it is a corporation, government, parcel of real
estate, or work of art. Even if there is no risk, you must be paid for the use of
liquidity that you give up to the investment (by investing).
Returns are the benefits from investing, but they must be larger than its costs.
There are at least two costs to investing: the opportunity cost of giving up cash and
giving up all your other uses of that cash until you get it back in the future and the
cost of the risk you take—the risk that you won’t get it all back.

Risk
Investment risk is the idea that an investment will not perform as expected, that its
actual return will deviate from the expected return. Risk is measured by the
amount of volatility, that is, the difference between actual returns and average
(expected) returns. This difference is referred to as the standard deviation27.
Returns with a large standard deviation (showing the greatest variance from the
average) have higher volatility and are the riskier investments.
As Figure 12.9 "S&P 500 Average Annual Return" shows, an investment may do
better or worse than its average. Thus, standard deviation can be used to define the
expected range of investment returns. For the S&P 500, for example, the standard
deviation from 1990 to 2008 was 19.54 percent. So, in any given year, the S&P 500 is
expected to return 9.16 percent but its return could be as high as 67.78 percent or
as low as −49.46 percent, based on its performance during that specific period.
What risks are there? What would cause an investment to unexpectedly over- or
underperform? Starting from the top (the big picture) and working down, there are
• economic risks,
• industry risks,
• company risks,
• asset class risks,
• market risks.
Economic risks are risks that something will upset the economy as a whole. The
economic cycle may swing from expansion to recession, for example; inflation or
deflation may increase, unemployment may increase, or interest rates may
fluctuate. These macroeconomic factors affect everyone doing business in the
economy. Most businesses are cyclical, growing when the economy grows and
contracting when the economy contracts.
Consumers tend to spend more disposable income when they are more confident
about economic growth and the stability of their jobs and incomes. They tend to be
more willing and able to finance purchases with debt or with credit, expanding
their ability to purchase durable goods. So, demand for most goods and services
increases as an economy expands, and businesses expand too. An exception is
27. In finance, the statistical businesses that are countercyclical. Their growth accelerates when the economy is
measure that calculates the in a downturn and slows when the economy expands. For example, low-priced fast
frequency and amount by
which actual returns differ
food chains typically have increased sales in an economic downturn because people
from the average or expected substitute fast food for more expensive restaurant meals as they worry more about
returns. losing their jobs and incomes.

Industry risks usually involve economic factors that

affect an entire industry or developments in technology Figure 12.10
that affect an industry’s markets. An example is the
effect of a sudden increase in the price of oil (a
macroeconomic event) on the airline industry. Every
airline is affected by such an event, as an increase in the
price of airplane fuel increases airline costs and reduces
profits. An industry such as real estate is vulnerable to
changes in interest rates. A rise in interest rates, for
example, makes it harder for people to borrow money to © 2010 Jupiterimages
finance purchases, which depresses the value of real Corporation
estate.
Company risk refers to the characteristics of specific

businesses or firms that affect their performance, making them more or less
vulnerable to economic and industry risks. These characteristics include how much
debt financing the company uses, how well it creates economies of scale, how
efficient its inventory management is, how flexible its labor relationships are, and
so on.
The asset class28 that an investment belongs to can also bear on its performance
and risk. Investments (assets) are categorized in terms of the markets they trade in.
Broadly defined, asset classes include
• corporate stock or equities (shares in public corporations, domestic, or

foreign);
• bonds or the public debts of corporation or governments;
• commodities or resources (e.g., oil, coffee, or gold);
• derivatives or contracts based on the performance of other underlying
assets;
• real estate (both residential and commercial);
• fine art and collectibles (e.g., stamps, coins, baseball cards, or vintage
cars).
Within those broad categories, there are finer distinctions. For example, corporate
stock is classified as large cap, mid cap, or small cap, depending on the size of the
corporation as measured by its market capitalization (the aggregate value of its
stock). Bonds are distinguished as corporate or government and as short-term,
intermediate-term, or long-term, depending on the maturity date.
28. A kind of investment
distinguished by its uses and
market (e.g., stock, bonds, fine Risks can affect entire asset classes. Changes in the inflation rate can make
art, real estate, currency). corporate bonds more or less valuable, for example, or more or less able to create

valuable returns. In addition, changes in a market can affect an investment’s value.

When the stock market fell unexpectedly and significantly, as it did in October of
1929, 1987, and 2008, all stocks were affected, regardless of relative exposure to
other kinds of risk. After such an event, the market is usually less efficient or less
liquid; that is, there is less trading and less efficient pricing of assets (stocks)
because there is less information flowing between buyers and sellers. The loss in
market efficiency further affects the value of assets traded.
As you can see, the link between risk and return is reciprocal. The question for
investors and their advisors is: How can you get higher returns with less risk?
KEY TAKEAWAYS
• There is a direct relationship between risk and return because investors

will demand more compensation for sharing more investment risk.
• Actual return includes any gain or loss of asset value plus any income
produced by the asset during a period.
• Actual return can be calculated using the beginning and ending asset
values for the period and any investment income earned during the
period.
• Expected return is the average return the asset has generated based on
historical data of actual returns.
• Investment risk is the possibility that an investment’s actual return will
not be its expected return.
• The standard deviation is a statistical measure used to calculate how
often and how far the average actual return differs from the expected
return.
• Investment risk is exposure to
◦ economic risk,
◦ industry risk,
◦ company- or firm-specific risk,
◦ asset class risk, or
◦ market risk.

EXERCISES
1. Selecting a security to invest in, such as a stock or fund, requires

analyzing its returns. You can view the annual returns as well as average
returns over a five-, ten-, fifteen-, or twenty-year period. Charts of
returns can show the amount of volatility in the short term and over the
longer term. What do you need to know to calculate the annual rate of
return for an investment? Consider that at the beginning of 2010 Ali
invests $5,000 in a mutual fund. The fund has a gain in value of $200, but
generates no income. What is the annual percentage rate of return?
What do you need to know to estimate the expected return of an
investment in the future? If the fund Ali invests in has an average
fifteen-year annual return of 7 percent, what percentage rate of return
should he expect for 2011? Find the estimated annualized rate of return
for a hypothetical portfolio by using the calculator at
http://www.mymoneyblog.com/estimate-your-portfolios-rate-of-
return-calculator.html.
2. Try the AARP’s investment return calculator at http://www.aarp.org/
money/investing/investment_return_calculator/, experimenting with
different figures to solve for a range of situations. Use the information
on that page to answer the following questions. Can the future rate of
return on an investment be estimated with any certainty? Do
investments that pay higher rates of return carry higher volatility? Do
investments that pay higher rates of return carry higher risk? What
accounts for differences between the actual return and the expected
return on an investment?
3. The standard deviation on the rate of return on an investment is a
measure of its volatility, or risk. What would a standard deviation of
zero mean? What would a standard deviation of 10 percent mean?
4. What kinds of risk are included in investment risk? Go online to survey
current or recent financial news. Find and present a specific example of
the impact of each type of investment risk. In each case, how did the
type of risk affect investment performance?

12.4 Diversification: Return with Less Risk
LEARNING OBJECTIVES
1. Explain the use of diversification in portfolio strategy.

2. List the steps in creating a portfolio strategy, explaining the importance
of each step.
3. Compare and contrast active and passive portfolio strategies.
Every investor wants to maximize return, the earnings or gains from giving up
surplus cash. And every investor wants to minimize risk, because it is costly. To
invest is to assume risk, and you assume risk expecting to be compensated through
return. The more risk assumed, the more the promised return. So, to increase
return you must increase risk. To lessen risk, you must expect less return, but
another way to lessen risk is to diversify—to spread out your investments among a
number of different asset classes. Investing in different asset classes reduces your
exposure to economic, asset class, and market risks.
Concentrating investment concentrates risk. Diversifying investments spreads risk

by having more than one kind of investment and thus more than one kind of risk.
To truly diversify, you need to invest in assets that are not vulnerable to one or
more kinds of risk. For example, you may want to diversify
• between cyclical and countercyclical investments, reducing economic

risk;
• among different sectors of the economy, reducing industry risks;
• among different kinds of investments, reducing asset class risk;
• among different kinds of firms, reducing company risks.
To diversify well, you have to look at your collection of investments as a whole—as a

portfolio—rather than as a gathering of separate investments. If you choose the
investments well, if they are truly different from each other, the whole can actually
be more valuable than the sum of its parts.
Steps to Diversification
In traditional portfolio theory, there are three levels or steps to diversifying: capital
allocation, asset allocation, and security selection.
387
Capital allocation29 is diversifying your capital between risky and riskless

investments. A “riskless” asset is the short-term (less than ninety-day) U.S.
Treasury bill. Because it has such a short time to maturity, it won’t be much
affected by interest rate changes, and it is probably impossible for the U.S.
government to become insolvent—go bankrupt—and have to default on its debt
within such a short time.
The capital allocation decision is the first diversification decision. It determines the
portfolio’s overall exposure to risk, or the proportion of the portfolio that is
invested in risky assets. That, in turn, will determine the portfolio’s level of return.
The second diversification decision is asset allocation30, deciding which asset

classes, and therefore which risks and which markets, to invest in. Asset allocations
are specified in terms of the percentage of the portfolio’s total value that will be
invested in each asset class. To maintain the desired allocation, the percentages are
adjusted periodically as asset values change. Figure 12.11 "Proposed Asset
Allocation" shows an asset allocation for an investor’s portfolio.
Figure 12.11 Proposed Asset Allocation
29. A strategy of diversifying a

portfolio between risky and
riskless assets.
30. The strategy of achieving

portfolio diversification by
Asset allocation is based on the expected returns and relative risk of each asset class
investing in different asset
classes. and how it will contribute to the return and risk of the portfolio as a whole. If the
12.4 Diversification: Return with Less Risk 388

asset classes you choose are truly diverse, then the portfolio’s risk can be lower
than the sum of the assets’ risks.
One example of an asset allocation strategy is life cycle investing31—changing your

asset allocation as you age. When you retire, for example, and forgo income from
working, you become dependent on income from your investments. As you
approach retirement age, therefore, you typically shift your asset allocation to less
risky asset classes to protect the value of your investments.
Security selection32 is the third step in diversification, choosing individual

investments within each asset class. Here is the chance to achieve industry or sector
and company diversification. For example, if you decided to include corporate stock
in your portfolio (asset allocation), you decide which corporation’s stock to invest
in. Choosing corporations in different industries, or companies of different sizes or
ages, will diversify your stock holdings. You will have less risk than if you invested
in just one corporation’s stock. Diversification is not defined by the number of
investments but by their different characteristics and performance.
Investment Strategies
Capital allocation decides the amount of overall risk in the portfolio; asset
allocation tries to maximize the return you can get for that amount of risk. Security
selection further diversifies within each asset class. Figure 12.12 "Levels of
Diversification" demonstrates the three levels of diversification.
Figure 12.12 Levels of Diversification
31. An investment strategy in

which asset allocation is based
on the investor’s age or stage
of life.
32. The process of choosing

individual securities to be
included in the portfolio.

Just as life cycle investing is a strategy for asset allocation, investing in index funds
is a strategy for security selection. Indexes are a way of measuring the performance
of an entire asset class by measuring returns for a portfolio containing all the
investments in that asset class. Essentially, the index becomes a benchmark33 for
the asset class, a standard against which any specific investment in that asset class
can be measured. An index fund is an investment that holds the same securities as
the index, so it provides a way for you to invest in an entire asset class without
having to select particular securities. For example, if you invest in the S&P 500
Index fund, you are investing in the five hundred largest corporations in the United
States—the asset class of large corporations.
There are indexes and index funds for most asset classes. By investing in an index,
you are achieving the most diversification possible for that asset class without
having to make individual investments, that is, without having to make any security
selection decisions. This strategy of bypassing the security selection decision is
called passive management34. It also has the advantage of saving transaction costs
(broker’s fees) because you can invest in the entire index through only one
transaction rather than the many transactions that picking investments would
require.
In contrast, making security selection decisions to maximize returns and minimize

risks is called active management35. Investors who favor active management feel
that the advantages of picking specific investments, after careful research and
33. A standard, often an index of analysis, are worth the added transaction costs. Actively managed portfolios may
securities, representing an achieve diversification based on the quality, rather than the quantity, of securities
industry or asset class and used selected.
as an indicator of growth
potential or as a basis of
comparison for similar of
Also, asset allocation can be actively managed through the strategy of market
disparate industries or assets.
timing36—shifting the asset allocation in anticipation of economic shifts or market
34. An investment strategy that volatility. For example, if you forecast a period of higher inflation, you would
does not include security
reduce allocation in fixed-rate bonds or debt instruments, because inflation erodes
selection within an asset class;
the investment is expected to the value of the fixed repayments. Until the inflation passes, you would shift your
perform as well as the allocation so that more of your portfolio is in stocks, say, and less in bonds.
benchmark index.
35. An investment strategy that It is rare, however, for active investors or investment managers to achieve superior
includes security selection
within an asset class in order results over time. More commonly, an investment manager is unable to achieve
to outperform the asset class consistently better returns within an asset class than the returns of the passively
benchmark. managed index.Much research, some of it quite academic, has been done on this
36. The practice of basing subject. For a succinct (and instructive) summary of the discussion, see Burton G.
investment strategy on Malkiel, A Random Walk Down Wall Street, 10th ed. (New York: W. W. Norton &
predictions of future market Company, Inc., 2007).
changes or on asset return
forecasts.

KEY TAKEAWAYS
• Diversification can decrease portfolio risk through choosing

investments with different risk characteristics and exposures.
• A portfolio strategy involves
◦ capital allocation decisions,

◦ asset allocation decisions,
◦ security selection decisions.
• Active management is a portfolio strategy including security selection
decisions and market timing.
• Passive management is a portfolio strategy omitting security selection
decisions and relying on index funds to represent asset classes, while
maintaining a long-term asset allocation.

EXERCISES
1. What is the meaning of the expressions “don’t count your chickens

before they hatch” and “don’t put all your eggs in one basket”? How do
these expressions relate to the challenge of reducing exposure to
investment risks and building a high-performance investment portfolio?
View ING’s presentation and graph on diversification and listen to the
audio at http://www.ingdelivers.com/pointers/diversification. In the
example, how does diversification lower risk? Which business sectors
would you choose to invest in for a diversified portfolio?
2. Draft a provisional portfolio strategy. In My Notes or your personal
finance journal, describe your capital allocation decisions. Then identify
the asset classes you are thinking of investing in. Describe how you
might allocate assets to diversify your portfolio. Draw a pie chart
showing your asset allocation. Draw another pie chart to show how life
cycle investing might affect your asset allocation decisions in the future.
How might you use the strategy of market timing in changing your asset
allocation decisions? Next, outline the steps you would take to select
specific securities. How would you know which stocks, bonds, or funds
to invest in? How are index funds useful as an alternative to security
selection? What are the advantages and disadvantages of investing in an
index fund such as the Dow Jones Industrial Average? (Go to
http://money.cnn.com/data/markets/dow/ to find out.)
3. Do you favor an active or a passive investment management strategy?
Why? Identify all the pros and cons of these investment strategies and
debate them with classmates. What factors favor an active approach?
What factors favor a passive approach? Which strategy might prove
more beneficial for first-time investors?
4. View the online video blog “3 Keys to Investing” at
http://www.allbusiness.com/personal-finance/4968227-1.html. What
advice does the speaker, Miranda Marquit (October 26, 2007), have for
novice investors? According to this source, what are the three keys to
successful investing?

Chapter 13
Behavioral Finance and Market Behavior
Introduction
Much of what is known about finance and investments has come from the study of
economics. Classic economics assumes that people are rational when they make
economic or financial decisions. “Rational” means that people respond to incentives
because their goal is always to maximize benefit and minimize costs. Not everyone
shares the same idea of benefit and cost, but in a market with millions of
participants, there tends to be some general consensus.
This belief in rationality leads to the idea of market efficiency1. In an efficient

market, prices reflect “fundamental value” as appraised by rational decision makers
who have access to information and are free to choose to buy or sell as their
rational decisions dictate. The belief in efficiency assumes that when prices do not
reflect real value, people will notice and will act on the anomaly with the result that
the market “corrects” that price.
People are not always rational, however, and markets are not always efficient.
Behavioral finance2 is the study of why individuals do not always make the
decisions they are expected to make and why markets do not reliably behave as
they are expected to behave. As market participants, individuals are affected by
others’ behavior, which collectively affects market behavior, which in turn affects
all the participants in the market.
As an individual, you participate in the capital markets and are vulnerable to the
1. The idea that the market works individual and market behaviors that influence the outcomes of your decisions. The
best when prices reflect all
more you understand and anticipate those behaviors, the better your financial
available information,
implying that the market price decision making may be.
represents an unbiased
estimate with an equal chance
that stocks are over- or
undervalued.
2. The study of how cognitive and

emotional factors affect
economic decisions,
particularly how they affect
rationality in decision making.
393
Chapter 13 Behavioral Finance and Market Behavior
13.1 Investor Behavior
LEARNING OBJECTIVES
1. Identify and describe the biases that can affect investor decision
making.
2. Explain how framing errors can influence investor decision making.
3. Identify the factors that can influence investor profiles.
Rational thinking can lead to irrational decisions in a misperceived or

misunderstood context. In addition, biases can cause people to emphasize or
discount information or can lead to too strong an attachment to an idea or an
inability to recognize an opportunity. The context in which you see a decision, the
mental frame you give it (i.e., the kind of decision you determine it to be) can also
inhibit your otherwise objective view.Much research has been done in the field of
behavioral finance over the past thirty years. A comprehensive text for further
reading is by Hersh Shefrin, Beyond Greed and Fear: Behavioral Finance and the
Psychology of Investing (Oxford: Oxford University Press, 2002). Learning to recognize
your behaviors and habits of mind that act as impediments to objective decision
making may help you to overcome them.
Biases
One kind of investor behavior that leads to unexpected decisions is bias3, a

predisposition to a view that inhibits objective thinking. Biases that can affect
investment decisions are the following:
• Availability
• Representativeness
• Overconfidence
• Anchoring
• Ambiguity aversionHersh Shefrin, Beyond Greed and Fear: Understanding
Financial Behavior and the Psychology of Investing (Oxford: Oxford
3. A tendency or preference or University Press, 2002).
belief that interferes with
objectivity.
Availability bias4 occurs because investors rely on information to make informed
4. In finance, an investor’s
decisions, but not all information is readily available. Investors tend to give more
tendency to base the
probability of an event on the weight to more available information and to discount information that is brought to
availability of information. their attention less often. The stocks of corporations that get good press, for
394
example, claim to do better than those of less publicized companies when in reality
these “high-profile” companies may actually have worse earnings and return
potential.
Representativeness5 is decision making based on stereotypes, characterizations

that are treated as “representative” of all members of a group. In investing,
representativeness is a tendency to be more optimistic about investments that have
performed well lately and more pessimistic about investments that have performed
poorly. In your mind you stereotype the immediate past performance of
investments as “strong” or “weak.” This representation then makes it hard to think
of them in any other way or to analyze their potential. As a result, you may put too
much emphasis on past performance and not enough on future prospects.
Objective investment decisions involve forming expectations about what will

happen, making educated guesses by gathering as much information as possible and
making as good use of it as possible. Overconfidence6 is a bias in which you have
too much faith in the precision of your estimates, causing you to underestimate the
range of possibilities that actually exist. You may underestimate the extent of
possible losses, for example, and therefore underestimate investment risks.
Overconfidence also comes from the tendency to attribute good results to good
investor decisions and bad results to bad luck or bad markets.
Anchoring7 happens when you cannot integrate new information into your
thinking because you are too “anchored” to your existing views. You do not give
new information its due, especially if it contradicts your previous views. By
devaluing new information, you tend to underreact to changes or news and become
less likely to act, even when it is in your interest.
5. The practice of stereotyping
asset performance, or of
assuming commonality of Ambiguity aversion8 is the tendency to prefer the familiar to the unfamiliar or the
disparate assets based on
superficial, stereotypical traits.
known to the unknown. Avoiding ambiguity can lead to discounting opportunities
with greater uncertainty in favor of “sure things.” In that case, your bias against
6. A bias in which you have too uncertainty may create an opportunity cost for your portfolio. Availability bias and
much faith in the precision of
your estimates, causing you to
ambiguity aversion can also result in a failure to diversify, as investors tend to
underestimate the range of “stick with what they know.” For example, in a study of defined contribution
possibilities that actually exist. retirement accounts or 401(k)s, more than 35 percent of employees had more than
30 percent of their account invested in the employing company’s stock, and 23
7. A bias in which the investor
relies too heavily on limited percent had more than 50 percent of their retirement account invested in their
known factors or points of employer’s stockS. Holden and J. VanDerhei, “401(k) Plan Asset Allocation, Account
reference. Balances, and Loan Activity in 2002,” EBRI Issue Brief 261 (2003).—hardly a well-
8. A preference for known risks diversified asset allocation.
over unknown risks.
13.1 Investor Behavior 395

Framing
Framing9 refers to the way you see alternatives and define the context in which
you are making a decision.A. Tversky and D. Kahneman, “The Framing Decisions
and the Psychology of Choice,” Science 30, no. 211 (1981): 453–58. Your framing
determines how you imagine the problem, its possible solutions, and its connection
with other situations. A concept related to framing is mental accounting10: the way
individuals encode, describe, and assess economic outcomes when they make
financial decisions.R. Thaler, "Mental Accounting Matters," Journal of Behavioral
Decision Making 12, no. 3 (1999): 183–206. In financial behavior, framing can lead to
shortsighted views, narrow-minded assumptions, and restricted choices.
Every rational economic decision maker would prefer to

avoid a loss, to have benefits be greater than costs, to Figure 13.1
reduce risk, and to have investments gain value. Loss
aversion11 refers to the tendency to loathe realizing a
loss to the extent that you avoid it even when it is the
better choice.
How can it be rational for a loss to be the better choice?

Say you buy stock for $100 per share. Six months later,
the stock price has fallen to $63 per share. You decide
not to sell the stock to avoid realizing the loss. If there is
another stock with better earnings potential, however,
your decision creates an opportunity cost. You pass up
the better chance to increase value in the hopes that
your original value will be regained. Your opportunity
cost likely will be greater than the benefit of holding
your stock, but you will do anything to avoid that loss. Corporation
Loss aversion is an instance where a rational aversion
leads you to underestimate a real cost, leading you to
choose the lesser alternative.
9. The idea that the presentation
or perception of a decision
influences the deicision maker. Loss aversion is also a form of regret aversion. Regret is a feeling of responsibility
10. A preference to segregate for loss or disappointment. Past decisions and their outcomes inform your current
investment accounts by goals decisions, but regret can bias your decision making. Regret can anchor you too
and constraints, rather than to firmly in past experience and hinder you from seeing new circumstances. Framing
perceive the entire portfolio as
a whole. can affect your risk tolerance. You may be more willing to take risk to avoid a loss if
you are loss averse, for example, or you may simply become unwilling to assume
11. An investor’s preference to risk, depending on how you define the context.
avoid losses, even when the
costs outweigh the benefits, in
which case it is not the rational
economic choice.

Framing also influences how you manage making more than one decision
simultaneously. If presented with multiple but separate choices, most people tend
to decide on each separately, mentally segregating each decision.Hersh Shefrin,
Beyond Greed and Fear: Understanding Financial Behavior and the Psychology of Investing
(Oxford: Oxford University Press, 2002). By framing choices as separate and
unrelated, however, you may miss making the best decisions, which may involve
comparing or combining choices. Lack of diversification or overdiversification in a
portfolio may also result.
Investor Profiles
An investor profile12 expresses a combination of characteristics based on

personality traits, life stage, sources of wealth, and other factors. What is your
investor profile? The better you can know yourself as an investor, the better
investment decisions you can make.
Researchers have identified some features or characteristics of investors that seem

to lead to recognizable tendencies.A reference for this discussion is John L. Maginn,
Donald L. Tuttle, Jerald E. Pinto, and Dennis W. McLeavey, eds., Managing Investment
Portfolios: A Dynamic Process, 3rd ed. (Hoboken, NJ: John Wiley & Sons, Inc., 2007). For
example, stages of life have an effect on goals, views, and decisions, as shown in the
examples in Figure 13.2 "Life Stage Profiles".
Figure 13.2 Life Stage Profiles
12. A combination of
characteristics based on
personality traits, life stage,
and sources of wealth.

These “definitions” are fairly loose yet typical enough to think about. In each of
these stages, your goals and your risk tolerance—both your ability and willingness
to assume risk—change. Generally, the further you are from retirement and the loss
of your wage income, the more risk you will take with your investments, having
another source of income (your paycheck). As you get closer to retirement, you
become more concerned with preserving your investment’s value so that it can
generate income when it becomes your sole source of income in retirement, thus
causing you to become less risk tolerant. After retirement, your risk tolerance
decreases even more, until the very end of your life when you are concerned with
dispersing rather than preserving your wealth.
Risk tolerance and investment approaches are affected by more than age and
investment stage, however. Studies have shown that the source and amount of
wealth can be a factor in attitudes toward investment.John L. Maginn, Donald L.
Tuttle, Jerald E. Pinto, and Dennis W. McLeavey, eds., Managing Investment Portfolios:
A Dynamic Process, 3rd ed. (Hoboken, NJ: John Wiley & Sons, Inc., 2007).
Those who have inherited wealth or come to it “passively,” tend to be much more
risk averse than those who have “actively” created their own wealth.
Entrepreneurs, for example, who have created wealth, tend to be much more
willing to assume investment risk, perhaps because they have more confidence in
their ability to create more wealth should their investments lose value. Those who
have inherited wealth tend to be much more risk averse, as they see their wealth as
a windfall that, once lost, they cannot replace.
Active wealth owners also tend to be more active investors, more involved in
investment decisions and more knowledgeable about their investment portfolios.
They have more confidence in their ability to manage and to make good decisions
than do passive wealth owners, who haven’t had the experience to build confidence.
Not surprisingly, those with more wealth to invest tend to be more willing to
assume risk. The same loss of value is a smaller proportional loss for them than for
an investor with a smaller asset base.
Many personality traits bear on investment behavior, including whether you

generally are
• confident or anxious,
• deliberate or impetuous,
• organized or sloppy,
• rebellious or conventional,

• an abstract or linear thinker.
What makes you make the decisions that you make? The more aware you are of the
influences on your decisions, the more you can factor them in—or out—of the
investment process.
KEY TAKEAWAYS
• Traditional assumptions about economic decision making posit that

financial behavior is rational and markets are efficient. Behavioral
finance looks at all the factors that cause realities to depart from these
assumptions.
• Biases that can affect investment decisions are the following:
◦ Availability
◦ Representativeness
◦ Overconfidence
◦ Anchoring
◦ Ambiguity aversion
• Framing refers to the way you see alternatives and define the
context in which you are making a decision. Examples of framing
errors include the following:
◦ Loss aversion
◦ Choice segregation
• Framing is a kind of mental accounting—the way individuals classify,
characterize, and evaluate economic outcomes when they make
• Investor profiles are influenced by the investor’s
◦ life stage,
◦ personality,
◦ source of wealth.

EXERCISES
1. Debate rational theory with classmates. How rational or nonrational (or

irrational) do you think people’s economic decisions are? What are some
examples of efficient and inefficient markets, and how did people’s
behavior create those situations? In My Notes or your personal finance
journal record some examples of your nonrational economic behavior.
For example, describe a situation in which you decreased the value of
one of your assets rather than maintaining or increasing its value. In
what circumstances are you likely to pay more for something than it is
worth? Have you ever bought something you did not want or need just
because it was a bargain? Do you tend to avoid taking risks even when
the odds are good that you will not take a loss? Have you ever had a
situation in which the cost of deciding not to buy something proved
greater than buying it would have cost? Have you ever made a major
purchase without considering alternatives? Have you ever regretted a
financial decision to such an extent that the disappointment has
influenced all your subsequent decisions?
2. Angus has always held shares of a big oil company’s stock and has never
thought about branching out to other companies or industries in the
energy sector. His investment has done well in the past, proving to him
that he is making the right decision. Angus has been reading about
fundamental changes predicted for the energy sector, but he decides to
stick with what he knows. In what ways is Angus’s investment behavior
irrational? What kinds of investor biases does his decision making
reveal?
3. Complete the interactive investor profile questionnaire at
https://www11.ingretirementplans.com/webcalc/jsp/ws/
typeOfInvestor.jsp. According to this instrument, what kinds of
investments should you consider? Then refine your understanding of
your investor profile by filling out the more comprehensive interview
questions at http://www.karenibach.com/files/2493/
SEI%20Questionaire.pdf. In My Notes or your personal finance journal,
on the basis of what you have learned, write an essay profiling yourself
as an investor. You may choose to post your investor profile and
compare it with those of others taking this course. Specifically, how do
you think your profile will assist you and your financial advisor or
investment advisor in planning your portfolio?
4. Using terms and concepts from behavioral finance, how might you
evaluate the consumer or investor behavior shown in the following
photos? In what ways might these economic behaviors be regarded as
rational? In what contexts might these behaviors become irrational?

Figure 13.3
Corporation
Figure 13.4
Corporation

Figure 13.5
Corporation

13.2 Market Behavior
LEARNING OBJECTIVES
1. Define the role of arbitrage in market efficiency.

2. Describe the limits of arbitrage that may perpetuate market inefficiency.
3. Identify the economic and cultural factors that can allow market
inefficiencies to persist.
4. Explain the role of feedback as reinforcement of market inefficiencies.
Your economic behaviors affect economic markets. Market results reflect the
collective yet independent decisions of millions of individuals. There have been
years, even decades, when some markets have not produced expected or “rational”
prices because of the collective behavior of their participants. In inefficient
markets, prices may go way above or below actual value.
The efficient market theory13 relies on the idea that investors behave rationally
and that even when they don’t, their numbers are so great and their behavioral
biases are so diverse that their irrational behaviors will have little overall effect on
the market. In effect, investors’ anomalous behaviors will cancel each other out.
Thus, diversification (of participants) lowers risk (to the market).
Another protection of market efficiency is the tendency for most participants to

behave rationally. If an asset is mispriced so that its market price deviates from its
intrinsic value, knowledgeable investors will see that and take advantage of the
13. The idea that the market works opportunity. If a stock seems underpriced they will buy, driving prices back up. If a
best when prices reflect all
stock seems overpriced, they will sell, driving prices back down. These strategies
available information,
implying that the market price are called arbitrage14, or the process of creating investment gains from market
represents an unbiased mispricings (arbitrage opportunities15). The knowledgeable investors who carry
estimate with an equal chance out market corrections through their investment decisions are called
that stocks are over- or
undervalued.
arbitrageurs16.
14. Trading that profits from the

market mispricing of assets in
the capital markets.
15. A market mispricing that

provides an opportunity for
unusual gain or loss.
16. Traders who seek arbitrage

opportunities.
403
There are limits to arbitrage, however. There are times

when the stock markets seem to rise or fall much more Figure 13.6
or for much longer than the dynamics of market
correction would predict.
Limits of Arbitrage
Arbitrage may not work when the costs outweigh the

benefits. Investment costs include transaction costs,
such as brokers’ fees, and risk, especially market risk.
An investor who sees an arbitrage opportunity would

have to act quickly to take advantage of it, because
chances are good that someone else will and the
advantage will disappear along with the arbitrage In the 1600s in Holland,
opportunity. Acting quickly may involve borrowing if speculators and investors drove
liquid funds are not available to invest. For this reason, up the price of tulip bulbs far
transaction costs for arbitrage trades are likely to be beyond their value. This
inefficient market, called “tulip
higher (because they are likely to include interest), and mania,” led to a “boom” or
if the costs are higher than the benefits, the market will “bubble,” followed by a “bust” or
not be corrected. “crash” when the market price
was corrected.Barbara
Schulman, “Tulips,” James Ford
The risk of arbitrage is that the investor rather than the Bell Library, University of
Minnesota, 1999,
market is mispricing stocks. In other words,
http://bell.lib.umn.edu/
arbitrageurs assume that the current valuation for an Products/tulips.html (accessed
asset will reverse—will go down if the valuation has May 28, 2009).
gone too high, or will go up if the valuation has gone too
low. If their analysis of fundamental value is incorrect, © 2010 Jupiterimages
the market correction may not occur as predicted, and Corporation
neither will their gains.
Most arbitrageurs are professional wealth managers.

They invest for very wealthy clients with a large asset base and very high tolerance
for risk. Arbitrage is usually not a sound practice for individual investors.
Causes of Market Inefficiency
Market inefficiencies can persist when they go undiscovered or when they seem
rational. Economic historians point out that while every asset “bubble” is in some
ways unique, there are common economic factors at work.Charles P. Kindleberger
and Robert Aliber, Manias, Panics, and Crashes, 5th ed. (Hoboken, NJ: John Wiley &
Sons, Inc., 2005). Bubbles are accompanied by lower interest rates, increased use of
13.2 Market Behavior 404

debt financing, new technology, and a decrease in government regulation or

oversight. Those factors encourage economic expansion, leading to growth of
earnings potential and thus of investment return, which would make assets
genuinely more valuable.
A key study of the U.S. stock market points out that there are cultural as well as
economic factors that can encourage or validate market inefficiency.Robert J.
Shiller, Irrational Exuberance, 2nd ed. (New York: Random House, Inc., 2005).
Examples include
• demographic factors of the population,

• attitudes reflected in the popular culture,
• the availability of information and analyses,
• the lowering of transaction costs.
These factors all lead to increased participation in the market and a tendency to
“rationalize irrationality,” that is, to think that real economic or cultural changes,
rather than mispricings, are changing the markets.
Sometimes mispricings occur when real economic and cultural changes are
happening, however, so that what used to be seen a mispricing is actually seen as
justifiable, fundamental value because the market itself has changed profoundly. An
example is the dotcom bubble of 1990–2000, when stock prices of Internet start-up
companies rose far higher than their value or earning capacity. Yet investors
irrationally kept investing until the first wave of start-ups failed, bursting the
market bubble.
Economic and cultural factors can prolong market inefficiency by reinforcing the
behaviors that created it, in a kind of feedback loop. For example, financial news
coverage in the media increased during the 1990s with the global saturation of
cable and satellite television and radio, as well as the growth of the Internet.Robert
J. Shiller, Irrational Exuberance, 2nd ed. (New York: Random House, Inc., 2005). More
information availability can lead to more availability bias. Stereotyping can develop
as a result of repeated “news,” resulting in representation bias, which encourages
overconfidence or too little questioning or analysis of the situation. Misinterpreting
market inefficiency as real changes can cause framing problems and other biases as
well.
In this way, market inefficiencies can become self-fulfilling prophecies. Investing in

an inefficient market causes asset values to rise, leading to gains and to more
investments. The rise in asset values becomes self-reinforcing as it encourages

anchoring, the expectation that asset values will continue to rise. Inefficiency
becomes the norm. Those who do not invest in this market thus incur an
opportunity cost. Participating in perpetuating market inefficiency, rather than
correcting it, becomes the rational choice.
Reliance on media experts and informal communication or “word of mouth”

reinforces this behavior to the point where it can become epidemic. It may not be
mere coincidence, for example, that the stock market bubble of the 1920s happened
as radio and telephone access became universal in the United States,See especially
Robert J. Shiller, Irrational Exuberance, 2nd ed. (New York: Random House, Inc.,
2005), 163. or that the stock boom of the 1990s coincided with the proliferation of
mobile phones and e-mail, or that the real estate bubble of the 2000s coincided with
our creation of the blogosphere.
Market efficiency requires that investors act independently so that the market
reflects the consensus opinion of their independent judgments. Instead, the market
may be reflecting the opinions of a few to whom others defer. Although the volume
of market participation would seem to show lots of participation, few are actually
participating. Most are simply following. The market then reflects the consensus of
the few rather than the many; hence, the probability of mispricing rises.
It is difficult to know what is happening while you are in the middle of an

inefficient market situation. It is easier to look back through market history and
point out obvious panics or bubbles, but they were not so obvious to participants
while they were happening. Hindsight allows a different perspective—it changes the
frame—but as events happen, you can only work with the frame you have at the
time.

KEY TAKEAWAYS
• The diversification of market participants should increase market

efficiency.
• Arbitrage corrects market mispricing.
• Arbitrage is not always possible, due to
◦ transaction costs,
◦ the risk of misinterpreting market mispricing.
• Market inefficiencies can persist due to economic and cultural

factors such as
◦ lowered interest rates and increased use of debt financing,

◦ new technology,
◦ a decrease in government regulation or oversight,
◦ demographic factors,
◦ attitudes as reflected in popular culture,
◦ the availability of information and its analysts,
◦ the lowering of transaction costs,
◦ increased participation in inefficient markets.
• Market mispricings can be reinforced by feedback mechanisms,
perpetuating inefficiencies.
EXERCISES
1. Find out more about the tulip mania at http://www.businessweek.com/

2000/00_17/b3678084.htm and at http://en.wikipedia.org/wiki/
Tulip_mania, or http://www.investopedia.com/features/crashes/
crashes2.asp. What caused mispricing in the market for tulip bulbs?
What factors perpetuated the market inefficiency? What happened to
burst the tulip bubble? What are some other examples from history of
similar bubbles and crashes caused by inefficient markets?
2. Reflect on your impact on the economy and the financial markets as an
individual, whether or not you are an investor. How does your financial
behavior affect the capital markets, for example? Record your thoughts
in your personal finance journal or My Notes. Share your ideas with
classmates.

13.3 Extreme Market Behavior
LEARNING OBJECTIVES
1. Trace the typical pattern of a financial crisis.

2. Identify and define the factors that contribute to a financial crisis.
Economic forces and financial behavior can converge to create extreme markets or
financial crises, such as booms, bubbles, panics, crashes, or meltdowns. These
atypical events actually happen fairly frequently. Between 1618 and 1998, there
were thirty-eight financial crises globally, or one every ten years.Charles P.
Kindleberger and Robert Aliber, Manias, Panics, and Crashes, 5th ed. (Hoboken, NJ:
John Wiley & Sons, Inc., 2005). As an investor, you can expect to weather as many as
six crises in your lifetime.
Patterns of events that seem to precipitate and follow the crises are shown in Figure
13.7 "Pattern of a Financial Crisis". First a period of economic expansion is sparked
by a new technology, the discovery of a new resource, or a change in political
balances. This leads to increased production, markets, wealth, consumption, and
investment, as well as increased credit and lower interest rates. People are looking
for ways to invest their newfound wealth. This leads to an asset bubble, a rapid
increase in the price of some asset: bonds, stocks, real estate, or commodities such
as cotton, gold, oil, or tulip bulbs that seems to be positioned to prosper from this
particular expansion.
Figure 13.7 Pattern of a Financial Crisis
408
The bubble continues, reinforced by the behavioral and market consequences that
it sparks until some event pricks the bubble. Then asset values quickly deflate, and
credit defaults rise, damaging the banking system. Having lost wealth and access to
credit, people rein in their demand for consumption and investment, further
slowing the economy.
Figure 13.8 "Major Asset Bubbles Since 1636" shows some of the major asset bubbles
since 1636 and the events that preceded them.Charles P. Kindleberger and Robert
Aliber, Manias, Panics, and Crashes, 5th ed. (Hoboken, NJ: John Wiley & Sons, Inc.,
2005).
Figure 13.8 Major Asset Bubbles Since 1636
In many cases, the event that started the asset speculation was not a
macroeconomic event but nevertheless had consequences to the economy: the end
of a war, a change of government, a change in policy, or a new technology. Often
the asset that was the object of speculation was a resource for or an application of a
new technology or an expansion into new territory that may have been critical to a
new emphasis in the economy. In other words, the assets that became the objects of
bubbles tended to be the drivers of a “new economy” at the time and thus were
rationalized as investments rather than as speculation.
13.3 Extreme Market Behavior 409

In all the examples listed in Figure 13.8 "Major Asset Bubbles Since 1636", as asset
values rose—even if only on the strength of investor beliefs—speculators, financed
by an expansion of credit, augmented the market and drove up asset prices even
further. Many irrational financial behaviors—overconfidence, anchoring,
availability bias, representativeness—were in play, until finally the market was
shocked into reversal by a specific event or simply sank under its own weight.
Economists may argue that this is what you should expect, that markets expand and
contract cyclically as a matter of course. In this view, a crash is nothing more than
the correction for a bubble—market efficiency at work.
Examples: The Internet Stock Boom and the Crash of 1929
Much has been and will be written about a classic financial crisis, the Internet stock
boom of the 1990s.For a wonderfully thorough and insightful start, see Robert J.
Shiller, Irrational Exuberance, 2nd ed. (New York: Random House, Inc., 2005). The
asset bubble was in the stocks of emerging companies poised to take advantage of
the “new economy” and its expanding markets of the new technology of the
Internet.
The asset bubble grew from preceding economic events. The previous decade had
seen a recovery from a major inflation and a recession in the United States followed
by an economic expansion. Deregulation and new technologies had opened up the
telecommunications industry. In 1989 the Soviet Union dissolved, opening markets
and market economies in Eastern Europe as well as the former Soviet Union (FSU).
The personal computer had taken hold and was gaining in household saturation.
This mix of relative prosperity, low inflation, new global markets, and new
technology looked very promising. Classically, the economy expanded, and a new
asset bubble was born.
Most Internet companies that were publicly traded were listed on the NASDAQ
exchange. Figure 13.9 "NASDAQ Composite Index, 1989–2008" shows the NASDAQ
composite index from 1991 to 2002.

Figure 13.9 NASDAQ Composite Index, 1989–2008Graph created by the author, based on data retrieved from
Yahoo! Finance, http://finance.yahoo.com (accessed October 21, 2009).
Between 1990 and 2000 the NASDAQ Composite Index increased ten-fold. At the
height of the bubble, between 1998 and 2000, the value of the index increased 2.5
times, resulting in an average annualized return of over 58 percent.
Alan Greenspan, then Chair of the Federal Reserve Bank, spoke on Capital Hill at the
end of January 1999. In response to the question about how much of the stock boom
was “based on sound fundamentals and how much is based on hype.” Greenspan
replied,
“First of all, you wouldn’t get ‘hype’ working if there weren’t something
fundamentally, potentially sound under it.
“The size of the potential market is so huge that you have these pie-in-the-sky type
of potentials for a lot of different [firms]. Undoubtedly, some of these small
companies whose stock prices are going through the roof will succeed. And they
may very well justify even higher prices. The vast majority are almost sure to fail.
That’s the way markets tend to work in this regard.…
“But there is at root here something far more fundamental—the stock market
seeking out profitable ventures and directing capital to hopeful projects before
profits materialize. That’s good for our system. And, in fact, with all its hype and
craziness, is something that, at the end of the day, is probably more plus than
minus.”John Cassidy, Dot.con (New York: HarperCollins, 2002), 202.
Greenspan implies that the bubble “with all its hype and craziness” is nothing more
than business as usual in the capital markets. He sees the irrational as somewhat
rational and not merely the “irrational exuberance” that he saw little more than

two years earlier.Robert J. Shiller, Irrational Exuberance, 2nd ed. (New York: Random
House, Inc., 2005), 1.
Going back a bit further, the Crash of 1929 was perhaps the most profound end to
an asset bubble, at least in the American psyche, as it seemed to precipitate a
lengthy depression, the Great Depression. The reasons for the prolonged recession
that followed the crash are complex, but the factors leading up to it illustrate a
classic asset bubble.
In the decade after World War I, the U.S. economy boomed. With the war over,
inflation eased and markets opened. Our manufacturing competitors in Europe had
suffered losses of labor, capital, and infrastructure that allowed the United States to
establish a global dominance. Technologies such as radio were changing the speed
of life, while the mass production of everything from cars to appliances was
changing the quality of life. Electrification and roads developed a national
infrastructure. To finance the consumption of all this mass production, the idea of
“store credit” was beginning to expand into the system of consumer credit that we
use today. As interest rates stayed low, levels of household and corporate debt rose.
New technologies were developed by new corporations that needed mass, public
financing. As more and more shares were issued, they were pitched more fervently
to encourage more investment by more investors. Investing became the national
pastime, share prices rose, and investors were reassured that technology had
spawned a new economy to create new wealth. As in the 1990s, the mix of relative
prosperity, low inflation, new global markets, and new technology looked very
promising. The positive feedback loop of a classic asset bubble had been created.
After it was all over, Groucho, one of the famous Marx Brothers comedians,
reflected on the rationalized irrationality of the bubble: “I would have lost more,
but that was all the money I had.”Julius Henry Marx, Groucho and Me (New York: Da
Capo Press, Inc., 1995), 197. Originally published in 1959.
Given that you can expect to encounter at least a few crises during your investing
lifetime, as you think about investing—creating and managing wealth—how can you
protect yourself? How can you “keep your head when all about you / Are losing
theirs,”Rudyard Kipling, Complete Verse (New York: Anchor Books, 1988). and is that
really the right thing to do?

KEY TAKEAWAYS
• Prolonged market inefficiencies can result in asset bubbles.
• Financial crises follow a typical pattern of
◦ economic expansion,
◦ asset bubble(s),
◦ market crash(es).
• The behavior that leads to financial crises may exhibit investor biases,
but to the extent that investors are responding to real changes in the
economy, it is not necessarily irrational.
EXERCISE
View a flowchart of the financial crisis of 2007 at Mint.com

(http://www.mint.com/blog/trends/a-visual-guide-to-the-financial-crisis/).
How did the real estate market become so inefficient? What thinking does
the chart identify that fed into the real estate crash? For each thought
bubble on the chart, what kind of bias or framing or other mental
accounting was taking place? In what ways was investor behavior irrational?
On the other hand, how might you argue that investors were not deciding
irrationally?

13.4 Behavioral Finance and Investment Strategies
LEARNING OBJECTIVES
1. Identify the factors that make successful market timing difficult.

2. Explain how technical analysis is used as an investment strategy.
3. Identify the factors that encourage investor fraud in an asset bubble.
You can apply your knowledge of findings from the field of behavioral finance in a
number of ways. First, you can be alert to and counteract your natural tendencies
toward investor bias and framing. For example, you can avoid availability bias by
gathering news from different sources and by keeping the news in historical
perspective.
A long-term viewpoint can also help you avoid anchoring or assuming that current
performance indicates future performance. At the same time, keep in mind that
current market trends are not the same as the past trends they may resemble. For
example, factors leading to stock market crashes include elements unique to each.
Ambiguity aversion can be useful if your uncertainty is caused by a lack of

information, as it can let you know when you need to do more homework. On the
other hand, aversion to ambiguity can blind you to promising opportunities.
Loss aversion, like any fear, is useful when it keeps you from taking too much risk,
but not when it keeps you from profitable opportunities. Using knowledge to best
assess the scope and probability of loss is a way to see the loss in context. Likewise,
segregating investments by their goals, risks, liquidity, and time horizons may be
useful for, say, encouraging you to save for retirement or some other goal.
Your best protection against your own behavioral impulses, however, is to have a
plan based on an objective analysis of goals, risk tolerance, and constraints, taking
your entire portfolio into account. Review your plan at least once a year as
circumstances and asset values may have changed. Having a plan in place helps you
counteract investor biases.
Following your investment policy or plan, you determine the capital and asset
allocations that can produce your desired return objective and risk tolerance within
414
your defined constraints. Your asset allocation should provide diversification, a

good idea whatever your investment strategy is.
Market Timing and Technical Analysis
Asset bubbles and market crashes are largely a matter of timing. If you could
anticipate a bubble and invest just before it began and divest just before it burst,
you would get maximum return. That sort of precise timing, however, is nearly
impossible to achieve. To time events precisely, you would constantly have to watch
for new information, and even then, the information from different sources may be
contradictory, or there may be information available to others that you do not
have. Taken together, your chances of profitably timing a bubble or crash are fairly
slim.
Market timing17 was defined in Chapter 12 "Investing" as an asset allocation

strategy. Because of the difficulty of predicting asset bubbles and crashes, however,
and because of the biases in financial behavior, individual investors typically
develop a “buy-and-hold” strategy. You invest in a diversified portfolio that reflects
your return objectives and risk tolerance, and you hold on to it. You review the
asset allocation periodically so it remains in line with your return and risk
preferences or as your constraints shift. You rely on your plan to make progress
toward your investment goals and to resist the temptations that are the subjects of
the field of behavioral finance.
As you read in Chapter 12 "Investing", a passive investment strategy ignores

security selection by using index funds for asset classes. An active strategy, in
contrast, involves selecting securities with a view to market timing in the selection
of securities and asset allocation.
17. The practice of basing An investment strategy based on the idea that timing is everything is called
investment strategy on technical analysis. Technical analysis18 involves analyzing securities in terms of
predictions of future market
their history, expressed, for example, in the form of charts of market data such as
changes or on asset return
forecasts. price and volume. Technical analysts are sometimes referred to as chartists.
Chartists do not consider the intrinsic value of a security—a concern of
18. A process of estimating fundamental analysis19. Instead, using charts of past price changes and returns,
security value solely on the
basis of past performance as an technical analysts try to predict a security’s future market movement.
indicator of future
performance.
Candlestick charting, with its dozens of symbols, is used as a way to “see” market
19. The process of estimating timing trends. It is believed to have been invented by an eighteenth-century
security value by evaluating
past performance and
Japanese rice trader named Homma Munehisa.Gregory L. Morris, Candlestick
macreconomic and industry Charting Explained: Timeless Techniques for Trading Stocks and Futures (New York:
factors. McGraw-Hill, 2006). Although charting and technical analysis has its proponents,
13.4 Behavioral Finance and Investment Strategies 415

fundamental analysis of value remains essential to investment strategy, along with

analyzing information about the economy, industry, and specific asset.
Figure 13.10 A Candlestick Chart Used in Technical AnalysisCourtesy of StockCharts.com,

http://stockcharts.com.
Technical analysts use charts like this one, showing the NASDAQ’s performance for April and May 2009. Each
symbol annotating the graph, such as the shaded and clear “candlesticks,” represents financial data. Chartists
interpret the patterns they see on these charts as indicators of future price moves and returns as driven by traders’
financial behavior.
Financial Fraud
Fraud is certainly not an investment strategy, but bubbles attract fraudulent

schemers as well as investors and speculators. A loss of market efficiency and signs
of greater investor irrationality attract con men to the markets. It is easier to
convince a “mark” of the credibility and viability of a fraudulent scheme when
there is general prosperity, rising asset values, and lower perceived risks.
During the post–World War I expansion and stock bubble of the 1920s, for example,
Charles Ponzi created the first Ponzi scheme20, a variation of the classic pyramid
20. A pyramid scheme practiced by scheme21. The pyramid scheme creates “returns” from new members’ deposits
Charles Ponzi in Boston during
the 1920s. The term is now rather than from real earnings in the market. The originator gets a number of
commonly used to describe a people to invest, each of whom recruits more, and so on. The money from each
pyramid scheme. group of investors, however, rather than being invested, is used to pay “returns” to
21. A fraud in which “returns” are the previous group of investors. The scheme is uncovered when there are not
created by new deposits rather enough “returns” to go around. Thus, the originator and early investors may get
than by real investment rich, while later investors lose all their money.
earnings.

During the prosperity of the 1980s, 1990s, and 2000s, the American financier
Bernard Madoff notoriously ran a variation of the Ponzi scheme. His fraud, costing
investors around the world billions of dollars, lasted through several stock bubbles
and a real estate bubble before being exposed in 2008.
Fraud can be perpetrated at the corporate level as well. Enron Corporation was an
innovator in developing markets for energy commodities such as oil, natural gas,
and electricity. Its image was of a model corporation that encouraged bright
thinkers to go “outside the box.” Unfortunately, that ethos of innovation took a
wrong turn when several of its corporate officers conspired to hide the company’s
investment risks from financing complicated subsidiaries that existed “off balance
sheet.” In the fall of 2001, with investor confidence shaken by the dotcom bust and
the post-9/11 deepening of the recession, the fraud began to unravel. By the time
the company declared bankruptcy, its stock value was less than one dollar per
share, and its major corporate officers were under indictment (and later convicted)
for fraud.
How can you avoid a fraud? Unfortunately, there are no foolproof rules. You can be
alert to the investment advisor who pushes a particular investment (see Chapter 14
"The Practice of Investment"). You can do your own research and gather as much
independent information on the investment as possible. The best advice, however,
may come in the adage, “If it seems too good to be true, it probably is.” The capital
markets are full of buyers and sellers of capital who are serious traders. The
chances are extremely slim that any one of them has discovered a market
inefficiency undiscoverable by others and exploitable only by him or her. There is
too much at stake.

KEY TAKEAWAYS
• Market timing, or the ability to predict bubbles and crashes, is

nearly impossible because of discrepancies in the
◦ availability of information,
◦ access to information,
◦ interpretation of information.
• Technical analysis is a strategy based on market timing and investor
sentiment.
• Asset bubbles are often accompanied by an increase in investor

fraud due to the
◦ loss of market efficiency,

◦ increase in investor “irrationality,”
◦ increase in wealth and prosperity.
• One form of financial fraud relating to market bubbles is the Ponzi
scheme or pyramid scheme.

EXERCISES
1. Consider exploring the world of chartists at

http://www.investopedia.com/articles/technical/02/121702.asp and
consider trying your hand at this arcane art. You and our classmates
might begin by learning how to read the charts that technical analysts
use to predict price changes in the markets. For a detailed glossary of
chart symbols and patterns, see http://www.trending123.com/patterns/
index.html. What do you see as the advantages and disadvantages of
technical analysis compared to fundamental analysis?
2. What is a pyramid scheme exactly? Find out at
http://www.investopedia.com/articles/04/042104.asp. Have you ever
participated in or invested in such a scheme? Have you ever been a
victim of one? Record your answers in My Notes or your personal
finance journal. According to the Investopedia article, why can it be
difficult to detect a pyramid scheme? What are some possible tip-offs to
this kind of fraud? Why are pyramid schemes unsustainable? Who are
the victims? Draw a diagram illustrating the dynamics of pyramid
schemes.
3. How are investment clubs different from pyramid schemes? Read about
investment clubs at http://www.ehow.com/how-
does_4566462_investment-club-work.html. What does the U.S. Securities
Exchange Commission have to say about investment clubs at
http://www.sec.gov/investor/pubs/invclub.htm? Investigate further
online. Would you consider joining or starting an investment club? Why,
or why not? What do your classmates think about this?
4. Survey the Web site of a 2009 60 Minutes CBS broadcast on the Madoff
affair, which includes articles, video, and links at
http://www.cbsnews.com/stories/2009/02/27/60minutes/
main4833667.shtml. According to this site, who discovered the Madoff
fraud and how? Who were Madoff’s victims? Visit the support group
Web site created for the victims at
http://berniemadoffponzisupportgroup.blogspot.com/. In the CBS
video, how did Madoff defend himself? Read a Wall Street Journal article
at http://online.wsj.com/article/SB123111743915052731.html,
explaining how Madoff’s Ponzi scheme was able to succeed. How did
investor biases contribute to this success? How did biases in regulatory
oversight contribute to the fraud? Sample some of the videos of the
congressional hearings on the Madoff scandal at
http://video.google.com/
videosearch?hl=en&q=madoff+fraud&um=1&ie=UTF-8&ei=
vSk1Sq2iOsGHtgfduMC8CQ&sa=X&oi=
video_result_group&resnum=7&ct=title#. Why did representatives and

senators focus their criticism on the Securities and Exchange

Commission?

Chapter 14
The Practice of Investment
Introduction
Once you have developed your investment policy statement and have determined
your goals, risk tolerance, and constraints, it is time to choose a strategy and to act.
Whether you entrust a professional advisor or you do it yourself—or both—depends
on your confidence, knowledge, and the time and effort that you want to devote to
your decisions. As is true of any personal finance decision, the ultimate
responsibility for and consequences of your decisions are yours alone. Whatever
you decide, the more you know about the practice of investment, the better an
investor you will be.
There are four broad areas to take into account: (1) how
to find and evaluate the information you need, (2) the Figure 14.1
agents and fees involved in securities trading, (3) the
ethical standards and regulatory requirements of the
securities industry, and (4) the special considerations of
investing internationally.
Corporation
421
Chapter 14 The Practice of Investment
14.1 Investment Information
LEARNING OBJECTIVES
1. Explain how leading economic indicators are used to gauge the current
economic cycle and the outlook for the economy.
2. Explain how indexes are used to gauge financial market activity and as
benchmarks for asset classes and industries.
3. Identify and evaluate sources of information used to analyze and
forecast corporate performance.
4. Sample and evaluate media outlets providing investment information
and advice.
Investment information seems to be everywhere: in print, radio, television, and

Internet—24/7 and global. Successful investors are hailed as gurus and high-profile
financial news reporters become celebrities. No shortage of commentators and
pundits will analyze every morsel of news, but how can you find useful investment
information to make investment decisions? Even more important, how can you find
useful information that you can trust based on the reliability of its source?
Your investment decisions involve asset allocation and security selection. To make
those decisions, you need information that will help you form an idea of the
economy, industry, and company that affect your decisions. The three main kinds
of information that investors use are economic indicators, market indexes, and
company performance.
Economic Indicators
To gauge the economic environment or cycle, the most widely used measures are
the following:
• Gross domestic product (GDP) is a common measure of the value of

output.
• Inflation measures the currency’s purchasing power.
• Unemployment measures the extent to which the economy creates
opportunities for participation.
• Interest rates affect the future value of money.
422
The U.S. government tracks GDP, inflation, and unemployment through its
agencies, such as the Federal Reserve Bank, the Bureau of Labor Statistics, and the
National Bureau of Economic Research. Globally, the World Bank tracks similar
statistics, which are widely reported in the media as recognized benchmarks1 of a
nation’s economic health.
In addition, interest rates are another financial market indicator. Interest rates are
tracked intently because so much capital investment, consumer investment (for
houses, cars, education), and even daily consumption relies on debt financing. The
prime rate, the lowest available retail interest rate, and average mortgage rates are
the most commonly followed rates.
Economists look at many other factors to measure the economy. The index of
leading economic indicators2, published monthly, includes the following:
1. The length of the average workweek (in hours)

2. Initial weekly claims for unemployment compensation
3. New orders placed with manufacturers
4. The percentage of companies receiving slower deliveries from
suppliers (vendor performance)
5. Contracts and orders for new plants and equipment
6. Permits for new housing starts
7. The interest rate spread (difference) between the ten-year Treasury
bond and the Federal Reserve Funds rate, the “overnight rate” that
banks use to lend to each other
8. The index of consumer expectations (the University of Michigan Index)
9. Change in the value of the index of stock prices (for 500 common
stocks)
10. Change in the money supply.
All these measures indicate how productive the economy is, how successful it is at
creating jobs and incomes, and how much benefit it can create for consumers. A
decline in the leading indicators for three consecutive months is thought to be a
strong sign that the economy is in a downturn or even heading toward a recession.
1. A standard, often an index of
securities, representing an
industry or asset class and used Market Information
as an indicator of growth
potential or as a basis of
comparison for similar of The health of financial markets is gauged by the values of various securities indexes
disparate industries or assets. that show the growth or decline of prices in various markets. The indexes are used
2. A set of ten economic statistics
to gauge the movement, direction, and rate of change as well as nominal value.
that are used to assess the
potential for economic growth.
14.1 Investment Information 423

Figure 14.2 "Examples of Security Indexes" lists some examples of the many stock
indexes and bond indexes and the publicly traded securities they track.
Figure 14.2 Examples of Security Indexes
There is an index for anything that is traded: commodities, currencies, interest rate
futures, and so on. Measures of market momentum include statistics such as the
percentage of stocks that advanced (increased in value) or declined (decreased in
value) or the volume of shares bought and sold. If more stocks advanced than
declined, for example, that may suggest optimism for the stock market.
When interpreting index information, be aware of the investments an index

represents. For example, the Dow Jones Industrial Average, or “the Dow,” consists
of the equity values of only thirty companies of the more than five thousand
publicly traded companies. The Dow is quoted widely and regularly. It was started
in 1896 by Charles Dow, founder of Dow Jones, Inc., and the Wall Street Journal.

Figure 14.3 The Dow Jones Home Page
Some companies specialize in analyzing asset classes of particular securities. Two

well-known analysts of mutual fund performance are Morningstar
(http://www.morningstar.com), which is geared toward investors, and Lipper
Reports (http://www.lipper.com), which is geared toward investment managers.
Indexes are used as benchmarks for an asset class or a sector of the economy. The
Standard & Poor’s (S&P) 500 Index is used to benchmark the performance of large
company (large cap) stocks, for example, while the Dow Jones Transportation Index
is used to compare the performance of the transportation industry to that of other
industries.
Industry and Company Information
An industry’s media is another place to research how an industry is doing. Most

industries have online trade journals and magazines that can give you an idea of
industry activity, optimism, and overall health. Another source are companies that
specialize in research and analysis of industry and company data, such as Hoover’s
(http://www.hoovers.com) or Value Line (http://www.valueline.com).

When professionals analyze a company for its investment potential, they look first
at financial statements. You can access this data as well, because all publicly traded
corporations must file both annual and quarterly financial reports with the U.S.
Securities and Exchange Commission (SEC). Those files are then made available on
the SEC’s Web site (http://www.sec.gov/edgar) through Electronic Data Gathering
and Retrieval (EDGAR), the SEC’s data bank. The annual reports (10-Ks) are audited,
and the quarterly reports (10-Qs) are unaudited, but both have to show the
company’s financial statements and report on important developments and plans
or explain unusual financial results.
The 10-K and the 10-Q can give you a good sense of what and how the company has
been doing or planning for the future. Similar corporate information may be found
in the company’s annual report, sent to shareholders and also available on the
company’s Web site.
An annual report is a narrative of how the company is doing. It includes financial

statements, dated at least two years back so that you can see the company’s
progress. It also includes a discussion, presented by the company’s management, of
the company’s strategic plans, competitive environment, industry outlook,
particular risk exposures, and so on. You can get a good sense of how well
positioned the company is going forward from an annual report or 10-K.
Evaluating Sources of Information
Investment information is readily available. Accessing that information is easy, but

evaluating its reliability may be difficult, along with knowing how to use it. It is
important to distinguish between objective news and subjective commentary. A
reporter should be providing unbiased information, while a commentator is
providing a subjective analysis of it. A news article ideally conveys objective facts,
while an editorial or opinion provides subjective commentary. Both kinds of “news”
appear in all kinds of media, such as print, radio, television, and the Internet. Most
print publications have continually updated Web sites, some with streaming video,
and there are financial social networks and blogs providing online discussion and
observation.
As you explore the sources of financial news, you will develop a sense of which ones
are the most useful to you. Figure 14.4 "Sample of Financial News Sources" lists a
selection of financial news sites to explore.

Figure 14.4 Sample of Financial News Sources
As you survey these news sources, be aware of features that might lead you to trust
an online source of information. The following are some questions to help you
evaluate the credibility of a Web site:Dax R. Norman, “Web Sites You Can Trust,”
American Libraries (August 2006): 36. Also see the Librarians’ Internet Index of Web
Sites You Can Trust, http://lii.org/ (accessed June 2, 2009).
1. Can the content be corroborated? (Check some of the facts.)

2. Is the site recommended by a content expert? (Look for a rating or
recommendation.)
3. Is the author reputable? (Search on the author’s name.)
4. Do you see the site as accurate? (Check with other sources.)
5. Was the information reviewed by peers or editors? (Read the reviews
or logs.)
6. Is the author associated with a reputable organization? (Search on the
organization.)
7. Is the publisher reputable? (Search on the publisher’s name.)
8. Are the authors and sources identified? (Look for source citations or
references.)
9. Do you see the site as current? (Check “last updated” or headline date.)

10. Do other Web sites link to this one? (Look for links.)
11. Is the site recommended by a generalist? (Ask a librarian.)
12. Is the site recommended by an independent subject area guide? (See
site referrals.)
13. Does the domain include a trademark name? (Look for a trademark in
the URL.)
14. Is the site’s bias clear? (Read the “About.” Look for a statement of
purpose. Read the author’s profile.)
15. Does the site have a professional look? (Look for a clean design and
error-free writing.)
The more questions you can answer in the affirmative, the higher the credibility of
the Web site and the more you can trust it as a source of information. The same
questions can be extended to evaluate the reliability of specific online financial
news sources.
KEY TAKEAWAYS
• Useful investment information analyzes the current economic, industry,

and company performance.
• Leading economic indicators are used to gauge the current economic
cycle and the outlook for the economy.
• Indexes are used to gauge financial market activity and as benchmarks
for asset classes and industries.
• Analysis and forecasting of company performance is based on publicly
reported information from SEC filings and from corporate annual
reports.
• Many media provide investment information and advice for both
experienced and novice individual investors, and such advice is readily
available online.
• The key to finding useful information is in understanding the credibility
and reliability of its source.

EXERCISES
1. What four measures are the most important indicators of the health of
the economy? What are the other leading economic indicators? Go to a
financial news source to find out the status of all the economic
indicators at this time. Make note of your findings and the date for
purposes of comparison. How does the information inform you as an
investor? Discuss with classmates the implications of the economic
indicators for investing. For example, read the results of the most recent
Consumer Confidence Survey at http://www.conference-board.org/
economics/ConsumerConfidence.cfm. How might these survey results
inform you as an investor?
2. Read an article summarizing the index of leading economic indicators
for May 2009 at http://www.bloomberg.com/apps/
news?pid=20601103&sid=aNHH_lMhARc4. How might an investor have
used the reported information in making investment decisions? Survey
the indexes listed in Figure 14.2 "Examples of Security Indexes". What
role might each index play in choosing assets for a portfolio?
3. Visit the SEC’s EDGAR site at http://www.sec.gov/edgar.shtml. Take the
tutorial to familiarize yourself with how the site works and then click on
“Search for Company Filings.” Input the name of a company with
publicly traded stock of interest to you. Then click on the company’s
most recent annual report it filed with the SEC. Read the annual report
in its entirety, including parts you don’t understand. Jot down your
questions as you read as if you are thinking of buying shares in that
company. What information encourages you in that decision? What
information raises questions or concerns? Go to the company’s Web site
and check its online documents, news, updates, and the current status of
its stock. Are you further encouraged? Why or why not? Where can you
go next to get data and commentary about the company as an
investment opportunity?
4. Survey the news sources listed in Figure 14.4 "Sample of Financial News
Sources" and number the sites to rank them in order of their usefulness
to you at this time. Record in your personal finance journal or My Notes
your top five sources of financial information and why you chose them.
5. Have you ever mistaken a press release or a blog for hard news when
looking for information online? Read the interviews with journalists,
bloggers, and others debating the reliability and accuracy of news
disseminated through the Internet at http://www.pbs.org/wgbh/pages/
frontline/newswar/tags/reliability.html. This PBS Frontline special
delves into the questions of the credibility and reliability of news
information, including financial news and blogs that we access online.
Commentators include Ted Koppel, Larry Kramer, Eric Schmidt, Craig

Newmark, and others. Discuss with classmates the positions taken in

this debate. In My Notes or your personal finance journal, write an essay
expressing your own conclusions about trusting financial information
you find online and using it to make personal finance decisions.

14.2 Investing and Trading
LEARNING OBJECTIVES
1. Identify the important differences between types of investment agents.

2. Describe the different levels of service offered by investment agents.
3. Analyze the different fee and account structures available to investors.
4. Differentiate the types of trading orders and explain their roles in an
investment strategy.
The discussion of investment so far has focused on the ideas behind your
investment plan, but to be useful to you, your plan has to be implemented. You
have to invest, and then, over time, trade. How do you access the capital markets?
How and when do you buy, sell, or hold?
To answer these questions you need to know the types of agents who exercise
trades in the financial markets; the types of services, accounts, and fees they offer;
and the kinds of trading orders they execute on your behalf.
Agents: Brokers and Dealers
The markets or exchanges for stocks, bonds, commodities, or funds are membership
organizations. Unless you are a member of the exchange, you cannot trade on the
exchange without hiring an agent to execute trades for you. Trading essentially is
buying and selling.
As you’ve read in Chapter 12 "Investing", a broker3 is an agent who trades on

3. An intermediary that acts as an
behalf of clients to fulfill client directives. A dealer4 is a firm that is trading for its
agent for buyers or sellers to
arrange a trade. own account. Many firms act as broker-dealers5, trading on behalf of both clients
and the firm’s account. Many brokers, dealers, and broker-dealers are independent
4. A professional investor trading
firms, but many are subsidiaries or operations of large investment banks,
for its own account.
commercial banks, or investment companies.
5. An intermediary that acts as an
agent for buyers or sellers and
also trades for its own account. Firms may offer different levels of brokerage services:
6. An investor-broker
relationship where the broker • Discretionary trading6 means that the broker is empowered to make
is empowered to make
investment decisions and investment decisions and trades on behalf of the client.
trades on behalf of the client.
431
• Advisory dealing7 means that the broker provides advice and

guidance to the client, but investment decisions remain with the client.
• Execution-only8 service means that the broker’s only role is to execute
trades per the investor’s decisions.
Almost all brokerages provide online and mobile access, and most allow you to
access your account information, including trading history, and to place orders and
receive order confirmations online. Some discount brokers operate only online,
that is, they have no retail or storefront offices at all. This allows them to lower
costs and fees. Most brokerages still send out hard copies of such information as
well. Some also provide research reports and tools such as calculators and data for
making asset allocation decisions.
Fees
As firms offer different levels of service, their compensation or fee structures may
vary. A broker is compensated for executing a trade by receiving a commission
based on the volume of the security traded and its price. A discount broker may
offer lower commissions on trades but may provide execution-only services.
A firm may offer all levels of service or specialize in just one. Large discount brokers
such as Fidelity, Scottrade, or Charles Schwab may provide a full range of services
along with execution-only services that charge lower commissions on trades. Other
discount brokers and online-only brokers may charge a lower flat fee per trade,
rather than a commission on the amount of the trade. Some firms charge a
commission on trades and a fee for advisory or discretionary services. The fee is
usually a percentage of the value of the portfolio. Some charge a flat fee for a
quarterly or annual portfolio check-up and advisory services.
Both the commission-based and the fee-based compensation structures have critics.
7. An investor-broker The commission-based structure results in more compensation for the broker (and
relationship where the broker
more cost for you) if there are a greater number of trades. This can lead some
provides advice and guidance
to the client, but investment brokers to engage in excessive trading, called churning9—an unwarranted and
decisions remain the client’s. unnecessary amount of trading in your account for which the broker is being
compensated.
8. An investor-broker
relationship where the
broker’s only role is to execute
trades per the investor’s On the other hand, a fee structure based on a percentage of the value of the assets
decisions. under management can reward a broker for doing nothing. If the economy expands
and asset values rise, the value of the portfolio—and therefore the broker’s
9. A broker practice of executing
trades for a client’s account
compensation—may rise without any effort on the broker’s part.
solely to create commissions
for the broker.
14.2 Investing and Trading 432

The most economical recourse for an investor is to find a broker who charges a flat
fee for advisory services, independent of portfolio size, and discount fees for
commissions on trading. The costs of investing and trading depend on how much
trading you do and how involved you are in the investment decisions. The more of
the research and advisory work you do for yourself, the less your costs should be.
Brokerage Accounts
Two basic types of brokerage accounts are cash accounts or margin accounts. With
a cash account10, you can trade using only the cash you deposit into the account
directly or as a result of previous trades, dividends, or interest payments. The cash
account is the most common kind of brokerage account.
With a margin account11, you may trade in amounts exceeding the cash available
in the account, in effect borrowing from your broker to complete the financing of
the trade. The investor is said to be “trading on margin.” The broker usually
requires a minimum value for a margin account and extends credit based on the
value of the cash and securities in the portfolio. If your portfolio value drops below
the minimum-value threshold, perhaps because securities values have dropped,
then you may be faced with a margin call12. The broker calls on you to deposit
more into the account.
Investors pay interest on funds borrowed on margin. As regulated by the Federal

10. A brokerage account where Reserve, the amount of an investment financed by debt or bought on margin is
investments are paid for from
money on deposit.
limited. The margin requirement13 is the percentage of the investment’s value
that must be paid for in cash.
11. A brokerage account allowing
the investor to purchase
securities with funds borrowed Custodial accounts14 are accounts created for minors under the federal Uniform
from the broker.
Gifts to Minors Act (UGMA) of 1956 or the Uniform Transfers to Minors Act (UTMA)
12. The requirement that an of 1986. The account is legally owned by the minor and is in his or her name, but an
investor invest more capital to adult custodian must be named for the account. Otherwise, the owner of a
maintain the margin
brokerage account must be a legal adult. The account is created at a bank,
requirement, or the investor’s
equity in the investment. brokerage firm, or mutual fund company and is managed by an adult for an
underage child (as defined by the state).
13. The percentage of security
value that must represent
capital from the investor (as Establishing a brokerage account is as easy as opening a bank account or credit card
opposed to money borrowed
from the broker). account. You will need a good credit rating, especially for a margin account, a
reasonable source of income, and a minimum deposit of assets. Many brokers allow
14. A brokerage account for a you to transfer assets from another brokerage account with minimal effort.
minor, established with a
guardian (adult) who is
authorized to make trading
decisions.

Brokerage Orders
You need not be an expert in the arcane language brokers use to describe trades, so
long as you understand the basic types of orders you can request. Say you want to
buy a hundred shares of X Corporation’s common stock. You call your broker and
ask the price. The broker says that at this moment, the market is “50 bid-50.25 ask.”
Stock exchanges are auction markets; that is, buyers bid what they are willing to
pay and sellers ask what they’re willing to accept. If the market is “50 bid-50.25
ask,” this means that right now the consensus among buyers is that they are willing
to pay $50 per share, while sellers are willing to accept $50.25. The “bid-ask spread”
or difference is 25 cents.
If you then place a market order15 to buy a hundred shares, the order will be
executed at the lowest asking price—the least that the seller is willing to accept. In
other words, you will pay $50.25 per share, the asking price, to buy the stock.
You could also place a limit order16 to buy the shares when the price is lower, say
$45 per share (or to sell when the price is higher, say $55), specifying how long the
order is in effect. If the price goes down to $45 (or up to $55) within the period of
time, then your limit order will be filled, and otherwise it will not.
15. An order to trade at the market

price.
When you buy a security, you are said to have a long position17 in that security;
you own it. You could close out your position by selling it. When you “go long” in a
16. A trading order to buy or sell a security, you are expecting its value to rise, so that you can buy it for a lower price
security at a specific price.
and then sell it for a higher price.
17. Ownership of securities; used
in the strategy of “going long,”
which involves buying a Alternatively, you could create a short position18 in the security by borrowing it
security so that if the price from your broker, selling it, and then buying it back and returning it to your broker
rises, its sale will create a gain.
at some specified point in the future. When you “short” a security, you are
18. Owing securities because of expecting its value to decrease, so that you can sell it at a high price and then buy it
having borrowed them from a back at a lower price.
broker; used in the strategy of
“shorting,” which involves
borrowing and selling a Other specialized kinds of orders include a stop-loss order19, where you direct that
security so that if the price
falls, you can create a gain the stock be sold when it reaches a certain price (below the current price) in order
when the securities are to limit your potential loss if the value decreases. You can use a stop-buy order20 to
repurchased to be returned. buy a stock at a certain price (above the current price) if you have “shorted” a
19. An order to sell a security once security and want to limit your loss if its value rises.
its price has fallen below a
specified price.
If you are following a “buy-and-hold” strategy, you are establishing positions that
20. An order to buy a security once you plan to hold for a long time. With this strategy you probably will do well to use
its price has risen above a
specified price.

a market order. Over the long term that you hold your position, the daily
fluctuations in price won’t matter.
KEY TAKEAWAYS
• A broker trades on behalf of clients; a dealer trades for its own account,
and a broker-dealer does both.
• Brokers, dealers, and broker-dealers may be independent firms or
subsidiaries of investment banks, commercial banks, or investment
companies.
• Firms may offer several levels of brokerage services, defining

their roles as active manager, advisor, and/or traders:
◦ discretionary trading,
◦ advisory dealing,
◦ execution only.
• Brokerage fees are based on the level of service provided and

may consist of
◦ commissions on trading,
◦ advisory fees based on portfolio value, or
◦ a flat fee for management.
• Brokerage accounts may be
◦ cash accounts,
◦ margin accounts, or
◦ custodial accounts.
• Trading orders allow you to better execute a specific trading

strategy:
◦ market orders,
◦ limit orders,
◦ stop-loss orders, or
◦ stop-buy orders.

EXERCISES
1. Read the information at the following sites about choosing an

investment broker or brokerage firm:
http://beginnersinvest.about.com/od/choosingabroker/a/
brokeraccount.htm and http://www.msmoney.com/mm/investing/
inv_experts/brokerage_firms.htm. In My Notes or your personal finance
journal, record the top ten questions about a broker or brokerage that
will guide your choice. What answers will you be looking for? See how
the investment industry evaluates brokers at
http://www.smartmoney.com/investing/economy/smartmoneys-
annual-broker-survey-23119 and http://www.moneybluebook.com/
reviews-of-the-best-online-discount-brokers.
2. What information (or inspiration) useful for personal finance can you
get at Money Blue Book (http://www.moneybluebook.com)? How would
you evaluate the Money Blue Book Web site as a source of financial
news, information, and advice? In your opinion, how do sites such as
Money Chimp (http://www.moneychimp.com/), Cool Investing
(http://www.coolinvesting.com/), and Get Rich Slowly
(http://www.getrichslowly.org/blog/) compare?
3. At the following Web sites, survey the argots, or “secret”

vocabularies, that brokers use to discuss trades. From each
glossary select five words relevant to you and their definitions to
record in your personal finance journal or My Notes.
◦ Stock Trading: http://www.mytradingsystem.net/Glossary-

trading-terms.html
◦ Bond Trading: http://www.bondsonline.com/asp/trading/
glossary.asp
◦ Futures Trading: http://www.webtrading.com/glossary.htm
◦ Currency Trading (Foreign Exchange, or FOREX):
http://www.fxwords.com

14.3 Ethics and Regulation
LEARNING OBJECTIVES
1. Discuss the reasons that investing behavior may be unethical.

2. Identify the key professional responsibilities of investment agents.
3. Describe practices that investment agents should pursue or avoid to
fulfill their professional responsibilities.
4. Explain how investment agents are regulated.
5. Debate the role of government oversight in the securities industry.
Financial markets, perhaps more than most, seem to seduce otherwise good citizens
into unethical or even illegal behavior. There are several reasons:
1. Investing is a complex, volatile, and unpredictable process, such that

the complexity of the process lowers the probability of getting caught.
2. The stakes are high enough and the probability of getting caught is low
enough so that the benefits can easily seem to outweigh the costs. The
benefits can even blind participants to the costs of getting caught.
3. The complexity of the situation may allow some initial success, and the
unethical investor or broker becomes overconfident, encouraging
more unethical behavior.
4. Employers may put their employees under pressure to act in the
company’s interests rather than clients’ interests.
To counteract these realities there are three forces at work: market forces,
professional standards, and legal restrictions. But before these topics are discussed,
it is useful to review the differences between ethical and unethical, or professional
and unprofessional, behaviors in this context.
Professional Ethics
Investment intermediaries or agents such as advisors, brokers, and dealers have

responsibilities to their clients, their employers, and to the markets. In carrying out
these responsibilities, they should demonstrate appropriate professional conduct.
Professional conduct is ethical, that is, it is based on moral principles of right and
wrong as expressed in the profession’s standards of conduct.
437
Brokers and advisors should always deal objectively and fairly with clients, putting
clients’ interests before their own. In other words, a broker should always give
higher priority to the client’s wealth than to his or her own. When acting on a
client’s behalf, a broker should always be aware of the trust that has been placed on
him or her and act with prudence21 and care. The principle of due diligence22
stipulates, for example, that investment advisors and brokers must investigate and
report to the investor every detail of a potential investment.
Kim receives an order from a client to sell shares because the client believes the
stock price will drop. Kim believes the client is right and so decides to sell her own
personal shares in that stock as well. She places the order to sell her shares first, so
that if the price drops as she sells, her shares will be sold at a higher price. She
places the order to sell the client’s shares after the price has dropped. This practice
of taking advantage of the client by not putting the client first is called front-
running23. According to professional ethics, Kim should be putting her client’s
interest—and order—ahead of her own.
Professional ethics call for brokers and advisors to disclose any potential conflicts
of interest they may have. They also should be diligent and thorough when
researching investments and making recommendations and should have an
objective basis for their advice. Investment recommendations should be suitable for
the client, and advice should be given with the best interests of the client in mind.
Shonte is a financial advisor for a large broker-dealer

that has acquired a large position in a certain bond Figure 14.5
issue. It now owns a lot of bonds. Wanting to reduce the
company’s exposure to risk from that position, Shonte’s
boss suggests that whenever possible, she should advise
her clients to add this bond to their portfolios. That way
the company can use its clients to buy its bonds and
reduce its position. This conduct is unethical, however.
21. Acting with sound and Shonte should not automatically recommend the bond
responsible judgment; in to all her clients, because her advice should be based © 2010 Jupiterimages
investing, prudence implies a solely on the individual clients’ interests and needs, not Corporation
relative conservatism
regarding risk.
the company’s.
22. Competent and adequate

research into an investment An advisor or broker should
proposal to be able to project
its returns and its potential
risks. • be forthcoming about how the investment analysis was done and the
changes or events could affect the outcome;
23. An agent trading for its own
account before executing • not present himself or herself as a “guru” with a special or secret
trading orders for its clients. method of divining investment opportunities;
14.3 Ethics and Regulation 438

• clearly explain the logic and grounding for all judgments and advice;
• not try to pressure you into making an investment decision or use
threats or scare tactics to influence you;
• communicate regularly and clearly with you about your portfolio
performance and any market or economic changes that may affect its
performance.
In addition to being loyal to clients, brokers and advisors are expected to be loyal to
employers, the professions, and the financial markets. Accepting side deals, gifts, or
“kickbacks,” for example, may damage a company’s reputation, harm colleagues as
well as clients, and betray the profession. Loyalty to market integrity is shown by
keeping the markets competitive and fair. For example, brokers should use only
information available to all. Information from private sources to which others do
not have access is inside information24, and making trades on the basis of inside
information is called insider trading25.
For example, Jorge, a broker, just found out from a client that the company she
works for is about to be granted a patent for a new product. The information has
not yet been announced publicly, but it will almost certainly increase the value of
the company’s stock. Jorge is tempted to buy the stock immediately, before the
news breaks, both for his employer’s account and his own. He would almost surely
profit and gain points with his boss as well. But that would be wrong. Trading on
inside information would be disloyal to the integrity of the markets, and it is illegal.
Brokers and advisors should not manipulate markets or try to influence or distort
prices to mislead market participants. Attempts to do so have become more
widespread with the tremendous growth of electronic communications. For
example, Tom, a dealer, has just shorted a large position in a tech stock. On his
widely read blog, he announces that his “research” has revealed serious weaknesses
in the tech company’s marketing strategy and rumors of competitors’ greater
advantages in the market. Tom has no factual basis for his reporting, but if his
“news” causes the price of the tech stock to fall, he will profit from his short
position. Tom’s attempts to manipulate the market are unethical and
unprofessional.
Regulation of Advisors, Brokers, and Dealers

24. Information that is not publicly
available that has a material It is often said that the financial markets are self-regulating and self-policing.
effect on an investment’s
Market forces may be effective in correcting or preventing unprofessional conduct,
value.
but they often don’t, so there are also professional and legal sanctions.
25. The illegal practice of trading
securities based on nonpublic
or “inside” information.

Sanctions provide deterrence and punishment. Registered brokers and advisors,

and their firms, typically are members of professional organizations with
regulatory powers. For example, professional organizations have qualifications for
membership and may award credentials or accreditation that their members would
not want to lose.
There are many professional designations and accreditations in the investment

advising and brokerage fields (Chapter 1 "Personal Financial Planning"). However,
keep in mind that no professional affiliation or designation is required to give
investment advice.
The U.S. securities industry is formally regulated by federal and state governments.
Government sanctions and limits have been imposed gradually, usually after a
major market failure or scandal, and so form a collection of rules and laws overseen
by a variety of agencies.
The Securities and Exchange Commission (SEC) is a federal government agency

empowered to oversee the trading of securities and the exchanges in the capital
markets. It was created in 1934 in response to the behavior that precipitated the
stock market crash in 1929 and the subsequent failure of the banking system. The
SEC investigates illegal activities such as trading on insider information, front-
running, fraud, and market manipulation.
The SEC also requires information disclosures to inform the public about
companies’ financial performance and business strategy. Investors must report to
the SEC their intention to acquire more than 5 percent of a company’s shares, and
business executives must report to the SEC when they buy or sell shares in their
own company. The SEC then tries to minimize the use of insider information by
making it publicly available.
The SEC delegates authority to self-regulatory organizations (SROs)26, such as the

National Association of Securities Dealers (NASD), and the national stock exchanges,
such as the New York Stock Exchange (NYSE). NASD and the exchanges uphold
industry standards and compliance requirements for trading securities and
operating brokerages.
In 2007, the SEC created a new SRO that reincorporated the NASD, renamed as the
Financial Industry Regulatory Authority (FINRA). FINRA’s job is to focus exclusively
on the enforcement of rules governing the securities industry. In addition, Congress
26. A nongovernmental created the Municipal Securities Rulemaking Board (MSRB) as an SRO. The MSRB’s
organization that regulates a
profession or industry.

job is to create rules to protect investors involved with broker-dealers and banks
that trade in tax-exempt bonds and 529 college savings plans.
Figure 14.6 "Regulatory Environment of the U.S. Securities Industry" shows the
structure of the securities industry’s regulatory environment.
Figure 14.6 Regulatory Environment of the U.S. Securities Industry
The Federal Reserve regulates banks and the banking system. When investment
brokering and advising are services of investment or commercial banks, their
actions may fall under the control of both the SEC and the Fed, as well as state
banking and insurance regulators. States license investment agents. Also, each
state’s attorney general is responsible for investigating securities violations in that
state.
Government regulation of capital markets has long been a contentious issue in the
United States. During periods of expansion and rising asset prices, there is less call
for regulation and enforcement. Clients and investment agents may have fewer
complaints because of investment gains and increasing earnings. When a bubble
bursts or there is a true financial crisis, however, then investors demand
protections and enforcement.

For example, after the stock market crash in 1929 and the widespread bank failures
of 1930–1933, the Glass-Steagall Act was passed in 1933 to establish the Federal
Deposit Insurance Corporation (FDIC) and take measures to reduce market
speculation. A second Glass-Steagall Act, which was passed the same year and
officially named the Banking Act of 1933, separated investment and commercial
banking to reduce potential conflicts of interest when a bank is issuing securities
for a firm that it is also lending to. In 1999, however, after years of economic
expansion and at the height of the tech stock bubble, the Gramm-Leach-Bliley Act
effectively repealed the Banking Act of 1933, opening the way for the consolidation
of the banking industry. This consolidation led to the introduction of “one-stop-
shopping” banks, which provide investment, commercial, and retail banking
services all under one roof.
The financial and banking crisis that began in 2007 led to calls for increased
regulation and a larger role for the federal and state governments in regulating the
banking and securities industries. While history shows that the kinds of regulation
and amount of government oversight vary, there clearly will always be a role for
federal and state government regulators.
Investor Protection
As an investor, you have recourse if a broker or advisor has been unethical,

unprofessional, or criminal in his or her conduct. If the offending agent is working
for a brokerage firm or bank, a complaint to a superior is sometimes all that is
needed. The firm would prefer not to risk its reputation for one “bad apple.”
If you are not satisfied, however, you can lodge a formal complaint with a
professional organization such as the relevant SRO. The SROs have standard
procedures in place and will investigate your complaint. If necessary, the offender
will be punished by a suspension or permanent removal of his or her professional
designation or certification.
You can also complain to the SEC or a state or federal consumer protection agency,
file suit in civil court, or press for a criminal complaint. Due to their complexities,
investment cases are often somewhat difficult to prove, so you should consult with
an attorney who is experienced with such cases. Often when a broker or advisor has
used illegal practices, she or he has done so with more than one client. When you
are not the only victim, the state or federal prosecutor or your lawyer may choose
to bring a class action suit on behalf of all the client-victims.
As always, the best defense is to take care in choosing an investment advisor or

broker. Most investment agents are chosen by word of mouth, recommendations

from trusted family members, friends, or colleagues who have been satisfied clients.
Before you choose, check with the professional organization with which he or she
claims affiliation or certification and review any records of past complaints or
offenses. You can also check with government agencies such as your state’s
attorney general’s office.
Your choice of advisor or broker depends largely on your expected use of services,
as suggested in Figure 14.7 "Choosing an Investment Advisor or Broker".
Figure 14.7 Choosing an Investment Advisor or Broker
You will be investing over a lifetime. The economic, market, and personal
circumstances will change, and your plans and strategies will change, but your
advisors and brokers should be able to help you learn from experience and prosper
from—or despite—those changes.

KEY TAKEAWAYS
• Investing behavior may be unethical because
◦ its complexity lowers the probability of getting caught,

◦ the stakes are high,
◦ initial success may encourage more unethical behavior,
◦ companies may expect that their interests have priority.
• Investment agents have responsibilities to
◦ their clients,
◦ employers,
◦ professions,
◦ markets.
• To fulfill those responsibilities, brokers should always put the

interests of clients, employers, professions, and markets before
their own and so should not practice
◦ front-running,
◦ insider trading,
◦ market manipulation.
• Regulation of investment agents comes from
◦ market forces,
◦ professional associations and self-regulating organizations,
◦ state and federal government oversight and enforcement
agencies.
• Levels of government oversight are politically contentious and subject
to change.
• Through consumer protection laws, investors have recourse for losses
from unprofessional or illegal behavior. The best protection is to make
good choices among financial advisors and investment brokers.

EXERCISES
1. Read the Securities and Exchange Commission’s explanation of what it

does at http://www.sec.gov/about/whatwedo.shtml. In what ways is the
SEC your advocate as an investor? List your answers in your personal
finance journal or My Notes. Disclosure, fair dealing, and transparency
are the SEC’s watchwords. To what do they refer? The SEC is a complex
government agency. What are its divisions? What organizations does the
SEC work with? What laws does the SEC enforce? What number can you
call if you have a question or complaint about your experience as an
investor?
2. Go to the SEC’s site on self-regulatory organizations of the securities
industry at http://www.sec.gov/rules/sro.shtml. Click on an SRO and
read the new rules it is making. Discuss with classmates how you would
comment on them, as you are invited to do. Find out what is a national
market system plan, a category of SROs. What do the National Market
System (NMS) plans do? To see NMS plans in action, go to a Web site
where you can see streaming ticker tape, such as Google Finance at
http://www.google.com/finance. How does what you see on the
streaming ticker tape relate to the regulatory environment of the world
of investing?
3. Debate with classmates the desirability of government regulation of the
financial markets at the federal, state, and organizational levels. What
impacts do regulation and deregulation have on the economy, the
markets, and you as an investor? What are some concrete examples of
those impacts? Write an essay declaring and supporting your position
on this issue.

14.4 Investing Internationally: Risks and Regulations
LEARNING OBJECTIVES
1. Identify the unusual risks of foreign investing compared to domestic

investing.
2. Discuss the use of the Economic Freedom Index.
3. Explain the role of international investments in an investment strategy.
Investing is global. While the financial markets and the

capital markets may resemble a global village, it is also Figure 14.8
true that investing in assets governed by foreign
standards and regulations creates additional concerns.
Investments in foreign securities are used to diversify

an investment portfolio’s economic risk. The United
States, most nations in Europe, and Japan have highly
developed economies. Other economies may be
developing, such as India and China, or may be
Corporation
emerging, such as Nigeria and Bolivia, and may be using
different strategies to achieve different rates of growth.
The world economy is truly global, however, because
although different economies may be in different stages
of development, they are all intimately linked through trade.
Different economies offer different kinds of opportunities because of where they

are in their progress toward free-market economic diversification and stability.
Along with different opportunities, however, they also offer different risks.
These risks run the gamut from the challenge of interpreting information correctly
to the risk that too much or too little regulation will interfere with market forces.
International investing also embodies risks relating to foreign markets, economies,
currencies, and politics.
Investment Information
A general concern in international investing is the flow and quality of information.

You make investment decisions by gathering and evaluating information. That
446
information is useful to you because you know how to interpret it, because you
know the standardized way in which that information was gathered and prepared.
In the United States, financial statements are prepared using Generally Accepted
Accounting Principles or GAAP, the rules that frame accounting judgments. Those
statements may then be audited by an independent certified public accountant
(CPA) to assure that the accounting rules have been followed.
In other countries, however, accountants do not use GAAP but prepare financial
statements by somewhat different rules. Some of those differences relate
significantly to asset valuations, a key factor in your decision to invest. When you
read financial reports written for foreign companies, therefore, you need to remain
mindful that they are written under different rules and may not mean the same as
financial reports following the U.S. GAAP. At the very least, you should determine
whether the statements you are reading were independently audited.
Other countries also have different standards and procedures for making
information available to investors. One reason that the SEC requires filings of
annual and quarterly reports is to make information publicly and readily available.
Other countries may not have such corporate filing requirements. Information may
be harder to get, and the information that you do get may not be as complete or as
uniform.
Other kinds of information are also important. A good brokerage or advisory firm
will have analysts and researchers “on the ground,” tracking economic and cultural
influences in foreign countries as well as corporations with promising earnings.
Market, Economic, and Currency Risks
Unless a foreign security is listed on an American exchange, you or your broker will
have to purchase it through a foreign exchange. In the United States, a substantial
volume of trade keeps markets liquid, except in relatively rare times of crisis. This
may not be true on some foreign exchanges. In active major capital markets such as
in Western Europe and Japan, there will be plenty of liquidity, but in some emerging
markets, such as in Africa, there may not be. This means that your risk in holding
an investment increases, because you may find it difficult to sell when you want to,
just because the market is not liquid at that time.
Market risk also affects pricing. Market liquidity and the volume of trade helps the
market to function more efficiently in the pricing of assets, so you are more likely
to get a favorable price when trading.
14.4 Investing Internationally: Risks and Regulations 447

Foreign investments are often used to diversify domestic investments just because
foreign economies are different. They may be in different business cycles or in
different stages of development. While the United States has a long-established,
developed market economy, other countries may have emerging market economies
with less capitalization and less experience in market-driven economic patterns.
Other economies also have different strengths and weaknesses, sources of growth
and vulnerabilities. The U.S. economy is fairly well-diversified, whereas another
economy may be more dependent on fewer industries or on commodities or natural
resources whose prices are volatile. Prospects for economic growth may differ
based on health care and education, tax policies, and trade policies. You want to be
sure that your investment is in an economy that can nurture or at least
accommodate growth.
Perhaps the greatest risk in international investing is currency risk27, risk to the
value of the foreign currency. To invest overseas, you may have to use foreign
currency, and you receive your return in foreign currency. When you change the
foreign currency back into your own currency, differences in the values of the
currencies—the exchange rate—could make your return more or less valuable.
Tim decides to invest in a French business when the exchange rate between the
euro (France) and the dollar (U.S.) is €1.00 = $1.00. So, Tim buys €1,000 of the French
company’s stock for $1,000 (assuming no transaction costs for the currency
exchange or for broker’s fees). One year goes by and Tim decides to sell the stock.
The stock is the same price, €1,000, but the exchange rate has changed. Now €1.00 =
$0.87. If Tim sells his stock, even though its value has not changed, his €1,000 will
only come to $870. Tim has incurred a loss, not because the value of the investment
decreased, but because the value of his currency did.
The exchange rate between two currencies fluctuates, depending on many

macroeconomic factors in each economy. At times there can be considerable
volatility. Exchange rates are especially affected by inflation, especially when the
spread in exchange rates between two countries is greater. When you are investing
abroad, consider the time period you expect to hold your investment and the
outlook for exchange rate fluctuations during that period.
Political Risks
Governments protect an economy and participate in it as both consumers and

27. The risk that an investment
denominated in a different
producers. The extent to which they do so is a major difference among
currency will suffer a loss due governments and their economies.
to exchange rate volatility.

The government’s role in an economy influences its growth potential. When

investing in a foreign company, you should consider the government’s effect on its
growth. Economic and political stability are important indicators for growth.
Because investing is long term, investors try to predict an investment’s

performance, and forecasting requires a stable context. The type of economy or
government is less relevant than its relative stability. A country given to economic
upheaval or with a history of weak governments or high government turnover is a
less stable environment for investment.
Market-based economies thrive when markets thrive, so anything the government

does to support markets will foster a better environment for investing. While some
market regulation is helpful, too much may work against market liquidity and thus
investors. A central bank that can encourage market liquidity and help stabilize an
economy is also helpful.
In 1995 the Heritage Foundation and the Wall Street Journal created the Index of
Economic Freedom (IEF) to try to measure a country’s welcoming of investment and
encouragement of economic growth. Using data from the World Bank and the
International Monetary Fund (IMF), the IEF is based on ten indicators of economic
freedom that measure the governments’ support and constraint of individual
wealth and trade.
Figure 14.9 "2009 Index of Economic Freedom" shows the Index of Economic
Freedom compiled by the Heritage Foundation for 2009 (reproduced courtesy of the
Heritage Foundation). The blue countries, notably the United States, Canada, and
Australia, are the most “free” and the red countries (concentrated in central and
sub-Saharan Africa, parts of the Middle East, and some states of the former U.S.S.R.)
are the least.

Figure 14.9 2009 Index of Economic FreedomThe Heritage Foundation, “The Link between Economic
Opportunity and Prosperity: The 2009 Index of Economic Freedom,” http://www.heritage.org/index (accessed
June 2, 2009).
Governments can change, peacefully or violently, slowly or suddenly, and can even
change their philosophies in governing, especially as they affect participation in the
global economy. Fiscal, monetary, and tax policies can change as well as
fundamental attitudes toward entrepreneurship, ownership, and wealth. For
example, the sudden nationalization or privatization of companies or industries can
increase or decrease growth, return potential, market liquidity, volatility, and even
the viability of those companies or industries. Because changes in fundamental
government policies will affect the economy and its markets, you should research
the country to learn as much as possible about its political risks to you as an
investor.
Foreign Regulatory Environments
One of the largest political risks is regulatory risk: that a government will regulate
its economy too little or too much. Too little regulation would reduce the flow of
information, allowing companies to keep information from investors and to trade
on inside information. A lack of regulatory oversight would also allow more
unethical behavior, such as front-running and conflicts of interest.
Too much regulation, on the other hand, could stifle liquidity and also increase the
potential for government corruption. The more government officials oversee more
rules, the more incentive there may be for bribery, favoritism, and corruption,
raising transaction costs and discouraging investment participation.
In addition to a body of laws or rules, regulation also requires enforcement and

judicial processes to ensure compliance with those rules. If there is little respect for
the rule of law, or if the rule of law is not consistently enforced or is arbitrarily

prosecuted, then there is greater investment risk. Inappropriate levels of regulation

lead to increased information costs, transaction costs, and volatility.
Often, foreign investments seem promising in part because economic growth may
be higher in an emerging economy, and often, they are. Such economies often have
higher levels of risk, however, because of their emergent character. Before you
invest, you want to be aware of the political and regulatory environment as well as
the economic, market, and investment-specific risk.
KEY TAKEAWAYS
• The flow, quality, and comparability of information are concerns in

international investing.
• Investing internationally may pose unusual risks compared to

domestic investing, such as
◦ market or liquidity risk,

◦ economic risk,
◦ currency risk,
◦ political risk,
◦ regulatory risk.
• The Index of Economic Freedom measures a country’s economic
environment, growth potential, and regulatory cost, which affect
investment risk.
• Greater investment risks require more research to gauge their effects on
an investment opportunity and the overall investing environment.

EXERCISES
1. Go to the Web site of the International Accounting Standards Board

(IASB) at http://www.iasb.org/Home.htm. What is the IASB’s mission?
See http://www.iasb.org. What is the value of this mission for
international investing today? What are the International Financing
Reporting Standards (IFRS)? How could the IFRS strengthen the global
economy and aid investors in the international markets? Read the 2009
Technical Summary at http://www.iasb.org/NR/rdonlyres/4CF78A7B-
B237-402A-A031-709A687508A6/0/Framework.pdf. Write a summary of
the IASB’s “Framework for the Preparation and Presentation of
Financial Statements.” If adopted by countries in which you wish to
invest, how would this framework work to your advantage? Now read
Investopedia’s explanation of the differences between international
accounting standards (IAS) and the generally accepted accounting
standards (GAAP) used in the United States at
http://www.investopedia.com/ask/answers/05/
iasvsgaap.asp?viewed=1. What would be the advantage of every country
having the same GAAP?
2. Use the currency converters at http://www.xe.com/ucc and
http://www.oanda.com/convert/classic to sample differences between
foreign currencies and the U.S. dollar. For example, how much is one
euro worth compared to the U.S. dollar? On the foreign currency
exchange what are the minimum bid and ask prices for euros? Did the
price rise or fall compared to the previous day? Check foreign exchange
rates at http://www.x-rates.com. Choose three currencies to compare
with the American dollar (USD) and look at the tables or graphs showing
the comparison history of those currencies. Which of the three
currencies has been the most volatile? Which currency is presently
closest to par with U.S. dollar?
3. Examine the Index of Economic Freedom at http://www.heritage.org/
Index. What is economic freedom? In the 2009 Index, which economies
are freer than the United States? Visit the World Bank at
http://www.worldbank.org and the IMF at http://www.imf.org/
external/about.htm. What role do these organizations play in
international finance? For example, what is the World Bank doing to
help increase investment opportunities in developing countries such as
the Republic of Indonesia? How does the IMF seek to strengthen the
international financial markets?

Chapter 15
Owning Stocks
Introduction
By 1976, computers had been around for decades. They were typically the size of a
large room and just as expensive. To use one, you had to learn a programming
language. On April 1, 1976, Steve Jobs, Steve Wozniak, and Ron Wayne started a
company to make personal computers. On January 3, 1977, Jobs and Wozniak
incorporated without Wayne, buying his 10-percent share of the company for
$800.Ronald W. Linzmayer, Apple Confidential: The Real Story of Apple Computer, Inc.
(San Francisco: No Starch Press, 1999). On December 12, 1980, Apple Computer, Inc.,
went public; its stock sold for $22 per share.FundingUniverse, “Company Histories:
Apple Computer, Inc.,” http://www.fundinguniverse.com/company-histories/
Apple-Computer-Inc- Company-History.html (accessed June 9, 2009). Had you
bought Apple’s stock when the company went public and held it until today, you
would have earned an annual return of about 14.5 percent. To look at it another
way, $1,000 invested in Apple shares when they went public would be worth over
$50,000 today.Calculations were done by the author, assuming a split-adjusted IPO
price of $2.75 per share (http://blogs.indews.com/financial_analysis/
apple_financial_analysis.php [accessed June 9, 2009]) and a current stock price of
$140 per share (June 2009).
History, as much as it is a litany of wars and rulers struggling for power, is a story of
invention and innovation, broadening our understanding of how the world works
and, if successful, improving the quality of our lives. Theoretical milestones have to
be made practical, however, to be truly effective. The steam engine, the light bulb,
the telephone—and the personal computer—had to be produced and sold to be
widely used and useful.
Typically, an inventor has a great idea, then teams up with—or becomes—an

entrepreneur. The entrepreneur’s job is to build a company that can make the
invention a reality. The company needs to find the resources to make the product
and sell it widely enough to pay for those resources and to create a profit, making
the whole effort worthwhile. No matter how great the idea is, if it can’t be done
profitably, it can’t be done.
453
Chapter 15 Owning Stocks
As an investor, you buy stocks hoping to share in corporate profits, benefiting

directly from the inventive vitality of the economy and participating in economic
growth. Understanding what stocks are, where they come from, what they do, and
how they have value will help you decide how to include stocks in your investment
portfolio and how to use them to reach your investment goals.
454
15.1 Stocks and Stock Markets
LEARNING OBJECTIVES
1. Explain the role of stock issuance and ownership in economic growth.

2. Contrast and compare the roles of the primary and secondary stock
markets.
3. Identify the steps of stock issuance.
4. Contrast and compare the important characteristics of common and
preferred stock.
5. Explain the significance of American Depository Receipts for U.S.
investors.
Resources have costs, so a company needs money, or capital, which is also a

resource. To get that start-up capital, the company could borrow or it could offer a
share of ownership, or equity, to those who chip in capital.
If the costs of debt (interest payments) are affordable, the company may choose to
borrow, which limits the company’s commitment to its capital contributor. When
the loan matures and is paid off, the relationship is over.
If the costs of debt are too high, however, or the

company is unable to borrow, it seeks equity investors Figure 15.1
willing to contribute capital in exchange for an
unspecified share of the company’s profits at some time
in the future. In exchange for taking the risk of no exact
return on their investment, equity investors get a say in
how the company is run.
Stock represents those shares in the company’s future

and the right to a say in how the company is run. The
original owners—the inventor(s) and
entrepreneur(s)—choose equity investors who share
their ideals and vision for the company. Usually, the
first equity investors are friends, family, or colleagues,
allowing the original owners freedom of management.
At that point, the corporation is privately held, and the
company’s stock may be traded privately between
455
owners. There may be restrictions on selling the stock,

often the case for a family business, so that control stays © 2010 Jupiterimages
within the family. Corporation
If successful, however, eventually the company needs

more capital to grow and remain competitive. If debt is
not desirable, then the company issues more equity, or stock, to raise capital. The
company may seek out an angel investor1, venture capital2 firm, or private
equity3 firm. Such investors finance companies in the early stages in exchange for a
large ownership and management stake in the company. Their strategy is to buy a
significant stake when the company is still “private” and then realize a large gain,
typically when the company goes public. The company also may seek a buyer,
perhaps a competitive or complementary business.
Alternatively, the company may choose to go public4, to sell shares of ownership to

investors in the public markets. Theoretically, this means sharing control with
random strangers because anyone can purchase shares traded in the stock market.
1. An individual or group
It may even mean losing control of the company. Founders can be fired, as Steve
providing equity financing; Jobs was from Apple in 1985 (although he returned as CEO in 1996).
usually a wealthy individual.
2. Private equity provided to Going public requires a profound shift in the corporate structure and management.
facilitate excessive growth
Once a company is publicly traded, it falls under the regulatory scrutiny of federal
before the initial public
offering of shares. and state governments, and must regularly file financial reports and analysis. It
must broaden participation on the board of directors and allow more oversight of
3. Equity not traded in a public
management. Companies go public to raise large amounts of capital to expand
market or exchange.
products, operations, markets, or to improve or create competitive advantages. To
4. To raise capital by issuing raise public equity capital, companies need to sell stock, and to sell stock they need
equity shares through a public
a market. That’s where the stock markets come in.
exchange.
5. Shares of common or preferred

stock that have been
Primary and Secondary Markets
authorized for issuance by a
corporation’s board of
The private corporation’s board of directors, shareholders elected by the
directors.
shareholders, must authorize the number of shares that can be issued. Since issuing
6. A company’s first issuance of shares means opening up the company to more owners, or sharing it more, only the
stock for trade in the public existing owners have the authority to do so. Usually, it authorizes more shares than
markets. Companies issue stock
publicly to attract more it intends to issue, so it has the option of issuing more as need be.
investors and thus more capital
for the company. When a
company has its IPO is it said to Those authorized shares5 are then issued through an initial public offering
“go public.” (IPO)6. At that point the company goes public. The IPO is a primary market7
7. The market in which the initial
transaction, which occurs when the stock is initially sold and the proceeds go to the
issuance or initial public company issuing the stock. After that, the company is publicly traded; its stock is
offering of a stock occurs. outstanding, or publicly available. Then, whenever the stock changes hands, it is a
15.1 Stocks and Stock Markets 456

secondary market8 transaction. The owner of the stock may sell shares and realize
the proceeds. When most people think of “the stock market,” they are thinking of
the secondary markets.
The existence of secondary markets makes the stock a liquid or tradable asset,
which reduces its risk for both the issuing company and the investor buying it. The
investor is giving up capital in exchange for a share of the company’s profit, with
the risk that there will be no profit or not enough to compensate for the
opportunity cost of sacrificing the capital. The secondary markets reduce that risk
to the shareholder because the stock can be resold, allowing the shareholder to
recover at least some of the invested capital and to make new choices with it.
Meanwhile, the company issuing the stock must pay the investor for assuming some
of its risk. The less that risk is, because of the liquidity provided by the secondary
markets, the less the company has to pay. The secondary markets decrease the
company’s cost of equity capital.
A company hires an investment bank to manage its initial public offering of stock.
For efficiency, the bank usually sells the IPO stock to institutional investors.
Usually, the original owners of the corporation keep large amounts of stock as well.
What does this mean for individual investors? Some investors believe that after an
initial public offering of stock, the share price will rise because the investment bank
will have initially underpriced the stock in order to sell it. This is not always the
case, however. Share price is typically more volatile after an initial public offering
than it is after the shares have been outstanding for a while. The longer the
company has been public, the more information is known about the company, and
the more predictable its earnings are and thus share price.M. B. Lowery, M. S.
Officer, and G. W. Schwert, “The Variability of IPO Initial Returns,” Journal of
Finance, http://schwert.ssb.rochester.edu/ipovolatility.htm (accessed June 9, 2009).
When a company goes public, it may issue a relatively small number of shares. Its
market capitalization9—the total dollar value of its outstanding shares—may
therefore be small. The number of individual shareholders, mostly institutional
investors and the original owners, also may be small. As a result, the shares may be
“thinly traded,” traded infrequently or in small amounts.
Thinly traded shares may add to the volatility of the share price. One large
8. A market in which outstanding
shares are traded. shareholder deciding to sell could cause a decrease in the stock price, for example,
whereas for a company with many shares and shareholders, the actions of any one
9. The total market value of a shareholder would not be significant. As always, diversification—in this case of
corporation’s capital.

shareholders—decreases risk. Thinly traded shares are less liquid and more risky
than shares that trade more frequently.
Common, Preferred, and Foreign Stocks
A company may issue common stock10 or preferred stock11. Common stock is

more prevalent. All companies issue common stock, whereas not all issue preferred
stock. The differences between common and preferred have to do with the
investor’s voting rights, risk, and dividends.
Common stock allows each shareholder voting rights—one vote for each share
owned. The more shares you own, the more you can influence the company’s
management. Shareholders vote for the company’s directors, who provide policy
guidance for and hire the management team that directly operates the corporation.
After several corporate scandals in the early twenty-first century, some
shareholders have become more active in their voting role.
Common stockholders assume the most risk of any

corporate investor. If the company encounters financial Figure 15.2
distress, its first responsibility is to satisfy creditors,
then the preferred shareholders, and then the common
shareholders. Thus, common stocks provide only
residual claims on the value of the company. In the
event of bankruptcy, in other words, common
shareholders get only the residue—whatever is left after
all other claimants have been compensated.
Corporation
Common shareholders share the company’s profit after
interest has been paid to creditors and a specified share
of the profit has been paid to preferred shareholders.
Common shareholders may receive all or part of the
profit in cash—the dividend. The company is under no obligation to pay common
stock dividends, however. The management may decide that the profit is better
used to expand the company, to invest in new products or technologies, or to grow
by acquiring a competitor. As a result, the company may pay a cash dividend only in
certain years or not at all.
10. Equity shares representing the
residual claim on the
company’s value. Shareholders investing in preferred stock, on the other hand, give up voting rights
but get less risk and more dividends. Preferred stock typically does not convey
11. Equity shares that represent a
superior claim over common
voting rights to the shareholder. It is often distributed to the “friends and family”
shares but typically do not of the original founders when the company goes public, allowing them to share in
confer voting rights. the company’s profits without having a say in its management. As noted above,

preferred shareholders have a superior claim on the company’s assets in the event
of bankruptcy. They get their original investment back before common
shareholders but after creditors.
Preferred dividends are more of an obligation than common dividends. Most

preferred shares are issued with a fixed dividend as cumulative preferred
shares12. This means that if the company does not create enough profit to pay its
preferred dividends, those dividends ultimately must be paid before any common
stock dividend.
For the individual investor, preferred stock may have two additional advantages
over common stock:
1. Less volatile prices

2. More reliable dividends
As the company goes through its ups and downs, the preferred stock price will
fluctuate less than the common stock price. If the company does poorly, preferred
stockholders are more likely to be able to recoup more of their original investment
than common shareholders because of their superior claim. If the company does
well, however, preferred stockholders are less likely to share more in its success
because their dividend is fixed. Preferred shareholders thus are exposed to less risk,
protected by their superior claim and fixed dividend. The preferred stock price
reflects less of the company’s volatility.
Because the preferred dividend is more of an obligation than the common dividend,
it provides more predictable dividend income for shareholders. This makes the
preferred stock less risky and attractive to an investor looking for less volatility and
more regular dividend income.
Figure 15.3 "Stock Comparisons" summarizes the differences between common

stock and preferred stock.
12. Preferred shares that obligate

the company to pay dividends
to preferred shareholders
before paying any others.

Figure 15.3 Stock Comparisons
As an investment choice, preferred stock is more comparable to bonds than to

common stock. Bonds also offer less volatility and more reliable income than
common stock (see Chapter 16 "Owning Bonds"). If there is a difference in the tax
rate between dividend income (from preferred stock) and interest income (from
bonds), you may find a tax advantage to investing in preferred stock instead of
bonds.
Corporations often issue and trade their stocks on exchanges or in markets outside
their home country, especially if the foreign market has more liquidity and will
attract more buyers. Many foreign corporations issue and trade stock on the New
York Stock Exchange (NYSE) or on the National Association of Securities Dealers
Automated Quotations (NASDAQ), for example.
Investing in foreign shares is complicated by the fact that stock represents

ownership, a legal as well as an economic idea, and because foreign companies
operate in foreign currencies. To get around those issues and make foreign shares
more tradable, the American Depository Receipt (ADR)13 was created in 1927. U.S.
banks buy large amounts of shares in a foreign company and then sell ADRs (each
representing a specified number of those shares) to U.S. investors. Individual shares
of the stock are called American Depository Shares, or ADSs.
The ADR is usually listed on a major U.S. stock exchange, such as the New York
Stock Exchange, or is quoted on the NASDAQ. One ADR can represent more or less
than one share of the foreign stock, depending on its price and the currency
exchange rate, so that the bank issuing the ADR can “price” it according to the
norms of U.S. stock markets.
13. An asset representing equity
shares in a foreign corporation
trading in U.S. markets.

ADRs lower transaction costs for U.S. investors investing in foreign corporations.
Because they are denominated in U.S. dollars, they lower exchange rate or currency
risk for U.S. investors. They also lower your usual risks with investing overseas,
such as lack of information and too much or too little regulatory oversight.
In return for marketing their shares in the lucrative U.S. market, foreign companies
must provide U.S. banks with detailed financial reports. This puts available foreign
corporate information on par with that of U.S. companies. Because they are issued
and sold in the United States on U.S. exchanges, ADRs fall under the regulatory
control of the Securities and Exchange Commission (SEC) and other federal and
state regulatory agencies, which also lowers your risk.
KEY TAKEAWAYS
• Companies go public to raise capital to finance growth by selling equity

shares in the public markets.
• A primary market transaction happens between the original issuer and
buyer.
• Secondary market transactions are between all subsequent sellers and
buyers.
• The secondary market lowers risk and transaction costs by increasing
liquidity.
• Shares are authorized and issued and then become outstanding or
publicly available.
• Equity securities may be common or preferred stock, differing by
◦ the assignment of voting rights,

◦ dividend obligations,
◦ claims in case of bankruptcy,
◦ risk.
• Common stocks have less predictable income, whereas most preferred
stocks have fixed-rate cumulative dividends.
• ADRs represent foreign shares traded in U.S. markets, lowering risks,
such as currency risks, and transaction costs for U.S. investors.

EXERCISES
1. See the video “Woz-Bing!” of Steve Wozniak, cofounder of Apple, Inc.,

(along with Steve Jobs and Ron Wayne) at http://finance.yahoo.com/
tech-ticker/article/255750/Woz-Bing!-Apple-Co-Founder-a- %22Big-
Fan%22-of-Microsofts-New-Search-Engine. In this Yahoo! video Wozniak
talks about Bing, a new search engine launched in 2009 as Microsoft’s
answer to Google. How does the discussion of this new technology relate
to understanding the role of stock investing in an economy? What
factors would you consider when deciding which investments in new
technology to include in your stock portfolio? Record your thoughts in
My Notes or your personal finance journal.
2. What is a venture capitalist? Watch noted venture capitalist (or VC) and
entrepreneur Guy Kawasaki at http://www.youtube.com/
watch?v=1etQC2-Vg_s. What three top pieces of advice does he give to
new ventures seeking equity investment? According to
http://www.investorwords.com/212/angel_investor.html, what is an
angel investor?
3. Explore Hoover’s at http://www.hoovers.com/global/ipoc/. What
information about IPOs can be found there? Click on a recently listed
IPO. Read about the company and click on its stock ticker symbol. What
was the price per share when the company was first listed on the stock
exchange? How many shares were sold? What is its price today? Where
did the proceeds from the IPO sale of shares go, and where will the
proceeds from sales on the secondary markets go?

15.2 Stock Value
LEARNING OBJECTIVES
1. Explain the basis of stock value.

2. Identify the factors that affect earnings expectations.
3. Analyze how market capitalization affects stock value.
4. Discuss how market popularity or perception of value affects stock
value.
5. Explain how stocks can be characterized by their expected performance
relative to the market.
The value of a stock is in its ability to create a return, to create income or a gain in
value for the investor. With common stock, the income is in the form of a dividend,
which the company is not obligated to pay. The potential gain is determined by
estimations of the future value of the stock.
If you knew that the future value would likely be more than the current market
price—over your transaction costs, tax consequences, and opportunity cost—then
you would buy the stock.
If you thought the future value would be less, you would short the stock (borrow it
to sell with the intent of buying it back when its price falls), or you would just look
for another investment.
Every investor wants to know what a stock will be worth, which is why so many
stock analysts spend so much time estimating future value. Equity analysis is the
process of gathering as much information as possible and making the most
educated guesses.
Corporations exist to make profit for the owners. The better a corporation is at
doing that, the more valuable it is, and the more valuable are its shares. A company
also needs to increase earnings, or grow, because the global economy is
competitive. A corporation’s future value depends on its ability to create and grow
earnings.
That ability depends on many factors. Some factors are company-specific, some are
specific to the industry or sector, and some are macroeconomic forces. Chapter 12
463
"Investing" discussed these factors in terms of the risk that a stock creates for the
investor. The risk is that the company will not be able to earn the expected profit.
A company’s size is an indicator of its earnings and growth potential. Size may
correlate with age. A large company typically is more mature than a smaller one,
for example. A larger company may have achieved economies of scale or may have
gotten large by eliminating competitors or dominating its market. Size in itself is
not an indicator of success, but similarly sized companies tend to have similar
earnings growth.E. F. Fama and K. R. French, “The Cross-section of Expected Stock
Returns,” Journal of Finance 47 (1992): 427–86.
Companies are usually referred to by the size of their market capitalization or

market cap, that is, the current market value of the debt and equity they use to
finance their assets. Common market cap categories are the sizes micro, small, mid
(medium), and large, or
• micro cap, with a market capitalization of less than $300 million;

• small cap, with a market capitalization between $300 million and $2
billion;
• mid cap, with a market capitalization between $2 billion and $10
billion;
• large cap, with a market capitalization of more than $10 billion.
The market capitalization of a company—along with industry and economic

indicators—is a valuable indicator of earnings potential.
The economist John Maynard Keynes (1883–1946) famously compared the securities
markets with a newspaper beauty contest. You “won” not because you could pick
the prettiest contestant, but because you could pick the contestant that everyone
else would pick as the prettiest contestant. In other words, the stock market is a
popularity contest, but the “best” stock was not necessarily the most popular.
Keynes described investing in the stock market as follows:
“The smart player recognizes that personal criteria of beauty are irrelevant in
determining the contest winner. A better strategy is to select those faces the other
players are likely to fancy. This logic tends to snowball. After all, the other
participants are likely to play the game with at least as keen a perception. Thus, the
optimal strategy is not to pick those faces the player thinks are prettiest, or those
the other players are likely to fancy, but rather to predict what the average opinion
15.2 Stock Value 464

is likely to be about what the average opinion will be.”Burton G. Malkiel, A Random
Walk Down Wall Street (New York: W. W. Norton & Company, Inc., 2007).
In the stock market, the forces of supply and demand determine stock prices. The
more demand or popularity there is for a company’s stock, the higher its price will
go (unless the company issues more shares). A stock is popular, and thus in greater
demand, if it is thought to be more valuable—that is, if it has more earnings and
growth potential.
Sometimes a company is under- or overpriced relative

to the going price for similar companies. If the market Figure 15.4
recognizes the “error,” the stock price should rise or fall
as it “corrects” itself.
A growth stock14 is a stock that promises a higher rate

of return because the market has underestimated its
growth potential. A value stock15 is a stock that has
been underpriced for some other reason. For example,
investors may be wary of the outlook for its industry. © 2010 Jupiterimages
Corporation
Because it is underpriced, a value stock is expected to
provide a higher-than-average return.
Stocks may be characterized by the role that they play

in a diversified portfolio—and some by their colorful names—as shown in Table 15.1
"Definitions of Stocks and their Roles in a Portfolio".
Table 15.1 Definitions of Stocks and their Roles in a Portfolio
Definition Role
Growth Underestimated potential

Expect a higher rate of return.
stock for growth.
14. A stock that is expected to Value Undervalued by the market;

offer excessive rates of growth.
Expect a higher-than-average return.
stock underpriced.
15. A stock whose return is based Less volatility than the
on its current underpricing by Defensive Expect the value to fall less than the market’s
overall market and less
the market. stock16 during a market decline.
sensitive to market changes.
16. A stock with very little volatility
that is relatively insensitive to More volatility than the When the market rises, expect the price to
Cyclical
market moves. overall market and more rise at a higher rate. When the market falls,
stock17
sensitive to market changes. expect the price to fall at a higher rate.
17. A stock that will move with the
market but with more volatility.

Definition Role
Speculative Overvalued by the market; Expect the price to continue rising for a time
stock18 overpriced. before it falls.
Stock of a stable, well-

Blue chip
established, large cap Expect stable returns.
stock19
company.
Widow-
and-
A blue chip defensive stock. Expect a steady dividend.
orphan
stock20
Wallflower Overlooked and therefore Expect the value to rise when the stock is
stock21 underpriced. “discovered.”
Penny Low-priced stock of a small Expect the value to rise if and when the
stock22 or micro cap company. company succeeds.
Each term in Table 15.1 "Definitions of Stocks and their Roles in a Portfolio" names
a stock’s relationship to the market and to investors. For example, an investor who
wants to invest in stocks but wants to minimize economic risk would include
defensive stocks such as Boeing (a large military contractor) in the stock portfolio
along with some blue chips, such as Coca Cola or Proctor and Gamble. Implicit is its
potential for price growth, risk, or role in a diversified portfolio.
KEY TAKEAWAYS
• A stock’s value is based on the corporation’s ability to create and grow

profits.
• Earnings expectations are based on economic, industry, and company-
specific factors.
• The size of the market capitalization affects stock value.
18. A stock promising excessive value
• A stock’s market popularity or perception of value affects its value.
that may already be overvalued.
19. Stock of a corporation with a • Stocks can be characterized by their expected behavior relative
history of providing steady
returns. to the market as
20. A blue chip stock that offers a

reliable dividend. ◦ growth stocks,
◦ value stocks,
21. A stock whose value is overlooked
by the market. ◦ cyclical stocks,
◦ defensive stocks, or
22. The stock of a corporation with
low market capitalization; the ◦ other named types (e.g., blue chip stocks, penny stocks).
stock has a low price (usually less
than one dollar) and high
volatility.

EXERCISES
1. Compare and contrast equity investment opportunities in relation to

market capitalization. Start by reading Forbes Magazine’s article on the
“Best 100 Mid-Cap Stocks in America” at http://www.forbes.com/2007/
09/25/best-midcap-stocks-07midcaps-cx_bz_0925midcap_land.html.
Click on one or more of the “top 10” and read about those companies.
According to Forbes, what is the advantage of investing in mid cap
stocks? Now go to the Securities and Exchange Commission’s (SEC) page
on micro cap stocks, also known as penny stocks, at
http://www.sec.gov/investor/pubs/microcapstock.htm. How are micro
cap stocks traded? Why might investors be attracted to micro cap
stocks? According to the government, what are four reasons that
investors should be wary of micro caps? What is a “pump and dump”
scheme?
2. Find and list examples of defensive and cyclical stocks online. Start at
http://www.bionomicfuel.com/stock-sector-classifications-defensive-
vs-cyclical/. What is a sector? What are the eleven sectors and which of
them are regarded as defensive? As an investor when might you
consider defensive stocks over cyclical stocks? Choose a sector that
interests you and read about small cap, mid cap, and large cap
companies in that sector. What are their stock prices? What do their
recent price histories tell you about their perceived value in the stock
market? Write your observations in My Notes or your personal finance
journal and share your observations with classmates.

15.3 Common Measures of Value
LEARNING OBJECTIVES
1. Identify common return ratios and evaluate their usefulness.

2. Explain how to interpret dividend yield.
3. Explain the significance of growth ratios.
4. Explain the significance of market value ratios.
A corporation creates a return for investors by creating earnings. Those earnings

may be paid out in cash as a dividend or retained as capital by the company. A
company’s ability to create earnings is watched closely by investors because the
company’s earnings are the investor’s return.
A company’s earnings potential can be tracked and measured, and several

measurements are expressed as ratios. Mathematically, as discussed in Chapter 3
"Financial Statements", a ratio is simply a fraction. In investment analysis, a ratio
provides a clear means of comparing values. Three kinds of ratios important to
investors are return ratios, growth ratios, and market value ratios.
The ratios described here are commonly presented in news outlets and Web sites
where stocks are discussed (e.g., http://www.nasdaq.com), so chances are you won’t
have to calculate them yourself. Nevertheless, it is important to understand what
they mean and how to use them in your investment thinking.
Return Ratios
One of the most useful ratios in looking at stocks is the earnings per share (EPS)23
ratio. It calculates the company’s earnings, the portion of a company’s profit
allocated to each outstanding share of common stock. The calculation lets you see
how much you benefit from holding each share. Here is the formula for calculating
EPS:
EPS = (net income − preferred stock dividends) ÷ average number of common shares
outstanding
23. The dollar value of the The company’s earnings are reported on its income statement as net income, so a
earnings per each share of shareholder could easily track earnings growth. However, EPS allows you to make a
common stock.
468
direct comparison to other stocks by putting the earnings on a per-share basis,

creating a common denominator. Earnings per share should be compared over time
and also compared to the EPS of other companies.
When a stock pays a dividend, that dividend is income for the shareholder.
Investors concerned with the cash flows provided by an equity investment look at
dividends per share24 or DPS as a measure of the company’s ability and willingness
to pay a dividend.
DPS = common stock dividends ÷ average number of common shares outstanding
Another measure of the stock’s usefulness in providing dividends is the dividend

yield25, which calculates the dividend as a percentage of the stock price. It is a
measure of the dividend’s role as a return on investment: for every dollar invested
in the stock, how much is returned as a dividend, or actual cash payback? An
investor concerned about cash flow returns can compare companies’ dividend
yields.
dividend yield = dividend per share (in dollars) ÷ price per share (in dollars)
For example, Microsoft, Inc., has a share price of around $24, pays an annual
dividend of $4.68 billion, and has about nine billion shares outstanding; for the past
year, it shows earnings of $15.3 billion.NASDAQ, http://quotes.nasdaq.com/asp/
SummaryQuote.asp?symbol=MSFT& selected=MSFT (accessed July 29, 2009).
Assuming it has not issued preferred stock and so pays no preferred stock
dividends,
EPS = 15.3 billion/9 billion = $1.70
DPS = 4.68 billion/9 billion = $0.52
dividend yield = 0.52/24 = 2.1667%
Microsoft earned $15.3 billion, or $1.70 for each share of stock held by stockholders,
from which $0.52 is actually paid out to shareholders. So if you buy a share of
Microsoft by investing $24, the cash return provided to you by the company’s
24. The dollar value of the dividend is 2.1667 percent.
dividend return to each share
of stock.
Earnings are either paid out as dividends or are retained by the company as capital.
25. The return provided by the
That capital is used by the company to finance operations, capital investments such
dividend relative to the share
price, or the dividend per each as new assets for expansion and growth or repayment of debt.
dollar of investment, given its
market price.
15.3 Common Measures of Value 469

The dividend is the return on investment that comes as cash while you own the
stock. Some investors see the dividend as a more valuable form of return than the
earnings that are retained as capital by the company. It is more liquid, since it
comes in cash and comes sooner than the gain that may be realized when the stock
is sold (more valuable because time affects value). It is the “bird in the hand,”
perhaps less risky than waiting for the eventual gain from the company’s retained
earnings26.
Some investors see a high dividend as a sign of the company’s strength, indicative
of its ability to raise ample capital through earnings. Dividends are a sign that the
company can earn more capital than it needs to finance operations, make capital
investments, or repay debt. Thus, dividends are capital that can be spared from use
by the company and given back to investors.
Other investors see a high dividend as a sign of weakness, indicative of a company

that cannot grow because it is not putting enough capital into expansion and
growth or into satisfying creditors. This may be because it is a mature company
operating in saturated markets, a company stifled by competition, or a company
without the creative resources to explore new ventures.
As an investor, you need to look at dividends in the context of the company and
your own income needs.
Growth Ratios
The more earnings are paid out to shareholders as dividends, the less earnings are
retained by the company as capital.
earnings = dividends + capital retained
26. The portion of the company’s

earnings or net income that is Since retained capital finances growth, the more earnings are used to pay
not distributed (paid out) to dividends, the less earnings are used to create growth. Two ratios that measure a
owners as a dividend, but is company’s choice in handling its earnings are the dividend payout rate and the
retained as equity financing for
retention rate. The dividend payout rate27 compares dividends to earnings. The
the company.
retention rate28 compares the amount of capital retained to earnings.
27. The percentage of earnings
that is paid out as a dividend.
The dividend payout rate figures the dividend as a percentage of earnings.
28. The rate at which a company
retains earnings for use as
additional capital or the dividend payout rate = dividends ÷ earnings
earnings retained (not paid out
as dividends) as a percentage
of earnings. The retention rate figures the retained capital as a percentage of earnings.

retention rate = capital retained ÷ earnings
Because earnings = dividends + capital retained, then
100% of earnings = dividend payout + retention rate.
If a company’s dividend payout rate is 40 percent, then its retention rate is 60

percent; if it pays out 40 percent of its earnings in dividends, then it retains 60
percent of them.
Since Microsoft has earnings of $15.3 billion and dividends of $4.68 billion, it must
retain $10.62 billion of its earnings. So, for Microsoft,
dividend payout rate = 4.68 billion/15.3 billion = 30.59%
retention rate = 10.62 billion/15.3 billion = 69.41%.
There is no benchmark dividend payout or retention ratio for every company; they
vary depending on the age and size of the company, industry, and economic
climate. These numbers are useful, however, to get a sense of the company’s
strategy and to compare it to competitors.
A company’s value is in its ability to grow and to increase earnings. The rate at
which it can retain capital, earn it and not pay it out as dividends, is a factor in
determining how fast it can grow. This rate is measured by the internal growth
rate29 and the sustainable growth rate. The internal growth rate answers the
question, “How fast could the company grow (increase earnings) without any new
capital, without borrowing or issuing more stock?” Given how good the company is
at taking capital and turning it into assets and using those assets to create earnings,
the internal growth rate looks at how fast the company can grow without any new
borrowing or new shares issued.
The sustainable growth30 rate answers the question, “How fast could the company
grow without changing the balance between using debt and using equity for
capital?” Given how good the company is at taking capital and turning it into assets
and using those assets to create earnings, the sustainable growth rate looks at how
fast the company can grow if it uses some new borrowing, but keeps the balance
29. The maximum rate of growth between debt and equity capital stable.
achieved without any issuance
of debt or new equity capital.
Both growth rates use the retention rate as a factor in allowing growth. The fastest
30. The maximum rate of growth
possible without changing the rate of growth could be achieved by having a 100 percent retention rate, that is, by
use of debt and equity capital. paying no dividends and retaining all earnings as capital.

An investor who is not using stocks as a source of income but for their potential
gain may look for higher growth rates (evidenced by a higher retention rate and a
lower dividend payout rate). An investor looking for income from stocks would
instead be attracted to companies offering a higher dividend payout rate and a
lower retention rate (despite lower growth rates).
Market Value Ratios
While return and growth ratios are measures of a company’s fundamental value,
and therefore the value of its stocks, the actual stock price is affected by the
market. Investors’ demand can result in underpricing or overpricing of a stock,
depending on its attractiveness in relation to other investment choices or
opportunity cost.
A stock’s market value can be compared with that of other stocks. The most
common measure for doing so is the price-to-earnings ratio31, or P/E. Price-to-
earnings ratio is calculated by dividing the price per share (in dollars) by the
earnings per share (in dollars). The result shows the investment needed for every
dollar of return that the stock creates.
P/E = price per share ÷ earnings per share
For Microsoft, for example, the price per share is around $24, and the EPS is $1.70,
so the P/E = 24.00/1.70 = $14.12. This means that the price per share is around
fourteen times bigger than the earnings per share.
The larger the P/E ratio, the more expensive the stock is and the more you have to
invest to get one dollar’s worth of earnings in return. To get $1.00 of Microsoft’s
earnings, you have to invest around $14. By comparing the P/E ratio of different
companies, you can see how expensive they are relative to each other.
A low P/E ratio could be a sign of weakness. Perhaps the company has problems
that make it riskier going forward, even if it has earnings now, so the future
expectations and thus the price of the stock is now low. Or it could be a sign of a
buying opportunity for a stock that is currently underpriced.
A high P/E ratio could be a sign of a company with great prospects for growth and
so a higher price than would be indicted by its earnings alone. On the other hand, a
31. The ratio of a stock’s market
value per share to its earnings high P/E could indicate a stock that is overpriced and has nowhere to go but down.
per share, or the market value In that case, a high P/E ratio would be a signal to sell your stock.
of one dollar of the company’s
earnings.

How do you know if the P/E ratio is “high” or “low”? You can compare it to other
companies in the same industry or to the average P/E ratio for a stock index of
similar type companies based on company size, age, debt levels, and so on. As with
any of the ratios discussed here, this one is useful in comparison.
Another indicator of market value is the price-to-book ratio (P/B)32. Price-to-book

ratio compares the price per share to the book value of each share. The book
value33 is the value of the company that is reported “on the books,” or the
company’s balance sheet, using the intrinsic or original values of assets, liabilities,
and equity. The balance sheet does not show the market value of the company’s
assets, for example, not what they could be sold for today; it shows what they were
worth when the company acquired them. The book value of a company should be
less than its market value, which should have appreciated over time. The company
should be worth more as times goes on.
P/B = price per share ÷ book value of equity per share
Since the price per share is the market value of equity per share, the P/B ratio
compares the current market value of the company’s equity to its book value. If that
ratio is greater than one, then the company’s equity is worth more than its original
value, and the company has been increasing its value. If that ratio is less than one,
then the company’s current value is less than its original value, so the value has
been decreasing. A P/B of one would indicate that a company has just been breaking
even in terms of value over the years.
The higher the P/B ratio, the better the company has done in increasing its value
over time. You can calculate the ratio for different companies and compare them by
their ability to increase value.
Figure 15.5 "Ratios and Their Uses" provides a summary of the return, growth, and
market value ratios.
32. A ratio comparing the market

value of the company to its
book or “original” value.
33. The valuation of assets,

liabilities, and equity from the
balance sheet; the
corporation’s original
investment in its assets,
liabilities, and equity.

Figure 15.5 Ratios and Their Uses
Ratios can be used to compare a company with its past performance, with its
competitors, or with competitive investments. They can be used to project a stock’s
future value based on the company’s ability to earn, grow, and be a popular
investment. A company has to have fundamental value to be an investment choice,
but it also has to have market value to have its fundamental value appreciated in
the market and to have its price reflect its fundamental value.
To go back to Keynes’s analogy: it may take beauty to win a beauty contest, but
beauty has to shine through to be appreciated by a majority of the judges. And
beauty, as you know, is in the eye of the beholder.

KEY TAKEAWAYS
• Earnings per share (EPS) and dividends per share (DPS) indicate stock
returns on investment.
• Dividend yield measures a shareholder’s cash return relative to
investment.
• Growth ratios such as the internal and sustainable growth rates indicate
the company’s ability to grow given earnings and dividend expectations.
• Market value ratios, most commonly price-to-earnings and price-to-
book, indicate a stock’s market popularity and its effects on its price.
EXERCISES
1. What do companies’ EPS tell an investor? Study examples of the return,

growth, and market value ratios, included among other business ratios
at http://www.investopedia.com/university/ratios/eps.asp. Look at the
raw data as well as the interpretation to grasp how the information
could inform an investment decision. For example, as an investor, would
you find the earnings-per-share ratio of Cory’s Tequila Co. encouraging
or discouraging? Click “Next” on each page of the Investopedia site to
get to each ratio analysis. For example, as an investor, what would you
make of the Cory’s Tequila Co.’s price-to-earnings ratio?
2. Find sample calculations online of the other ratios discussed in this
chapter. For example, study the example of calculating a company’s
dividend payout ratio and retained earnings at
http://www.accountingformanagement.com/
dividend_payout_ratio.htm. As an investor, what might you conclude
about the desirability of this company’s stock? Suppose a company has a
dividend per share ratio of $1.60, based on an original value of $8 per
share, and a dividend yield ratio of 6.4 percent, based on a market value
of $25 per share. As an investor, what does this information tell you?

15.4 Equity Strategies
LEARNING OBJECTIVES
1. Identify and explain the rationales behind common long-term

strategies.
2. Identify and explain the rationales behind common short-term
strategies.
The best stock strategy is to know what you are looking for (i.e., what kind of stock
will fulfill the role you want it to play in your portfolio) and to do the analyses you
need to find it. That is easier said than done, however, and requires that you have
the knowledge, skill, and data for stock analysis. Commonly used general stock
strategies may be long term (returns achieved in more than one year) or short term
(returns achieved in less than one year), but the strategies you choose should fit
your investing horizon, risk tolerance, and needs. An important part of that
strategy, as with financial planning in general, is to check your stock investments
and reevaluate your holdings regularly. How regularly depends on to long- or short-
term horizon of your investing strategies.
Long-Term Strategies
Long-term strategies favor choosing a long-term approach to avoid the volatility

and risk of market timing. For individual investors, a buy-and-hold strategy34 can
be effective over the long run. The strategy is just what it sounds like: you choose
the stocks for your equity investments, and you hold them for the long term. The
idea is that if you choose wisely and your stocks are well diversified, over time you
will do at least as well as the stock market itself. Though it suffers through
economic cycles, the economy’s long-term trend is growth.
34. The long-term strategy of

investing and holding without
trading.
476
By minimizing the number of transactions, you can

minimize transaction costs. Since you are holding your Figure 15.6
stocks, you are not realizing gains and are not paying
gains tax. Thus, even if your gross returns are not
spectacular, you are minimizing your costs and
maximizing net returns. This strategy is optimal for
investors with a long horizon, low risk tolerance, and
little need for liquidity in the short term.
Another long-term strategy is dollar-cost averaging35. © 2010 Jupiterimages

Corporation
The idea of dollar-cost averaging is that you invest in a
stock gradually by buying the same dollar amount of the
same stock at regular intervals. This is a way of negating
the effects of market timing. By buying at regular
intervals, you will buy at times when the price is low and when it is high, but over
time your price will average out. Dollar-cost averaging is a way of avoiding a stock’s
price volatility because the net effect is that you buy the stock at its average price.
An investor uses dollar-cost averaging when regular payroll deductions are made to
fund defined contribution retirement plans, such as a 401(k) or a 403b. The same
amount is contributed to the plan in regular intervals and is typically used to
purchase the same set of specified assets.
A buy-and-hold or dollar-cost averaging strategy only makes sense over time

because both assume a long time horizon in order to “average out” volatility,
making them better than other investment choices. If you have a long-term
horizon, as with a retirement plan, those strategies can be quite effective. However,
as the most recent decade has shown, market or economic cycles can be long too, so
you need to think about whether your “long-term” horizon is likely to outlast or be
outlasted by the market’s cycle, especially as you near your investment goals.
Direct investment and dividend reinvestment are ways of buying shares directly
from a company without going through a broker. This allows you to avoid
35. The strategy of investing brokerage commissions. Direct investment36 means purchasing shares from the
regular dollar amounts at company, while dividend reinvestment37 means having your dividends
regular intervals in one
automatically invested in more shares (rather than being sent to you as cash).
security.
Dividend reinvestment is also a way of building up your equity in the stock by
36. A real estate investment in reinvesting cash that you might otherwise spend.
which you are the owner and
manager of property.
The advantage of direct investment and dividend reinvestment is primarily the
37. The practice of using dividends
to automatically purchase savings on brokers’ commissions. You can also buy fractional shares or less than a
additional shares. whole share, and there is no minimum amount to invest, as there can be with
15.4 Equity Strategies 477

brokerage transactions. The disadvantage is that by having funds automatically

reinvested, you are not actively deciding how they should be invested and thus may
be missing better opportunities.
Indexing38 is a passive long-term investment strategy to invest in index funds as a

diversified asset rather than select stocks. Instead of choosing individual large cap
companies, for example, you could invest in Standard & Poor’s (S&P) 500 Index
fund, which would provide more diversification for only one transaction cost than
you could get picking individual securities. The disadvantage to indexing is that you
do not enjoy the potential of individual stocks producing above-average returns.
Figure 15.7 "Long-Term Stock Strategies" summarizes long-term stock strategies.
Figure 15.7 Long-Term Stock Strategies
Short-Term Strategies
Short-term stock strategies rely on taking advantage of market timing to earn

above-average returns. Some advisors believe that the stock market fluctuates
between favoring value stocks and favoring growth stocks. That is, the market will
go through cycles when value stocks that are temporarily underpriced will
outperform stocks of companies poised for higher growth, and vice versa. If true,
you would want to weight your portfolio with growth stocks when they are favored
and with value stocks when they are favored.
This value-growth weighting strategy relies on market timing, which is difficult for
38. The strategy of using index the individual investor. It also relies on correctly identifying growth and value
funds to achieve diversification stocks and market trends in their favor, complicating the process of market timing
rather than specifically even further.
selecting individual securities.

Day trading39 is a very short-term strategy of taking and closing a position in a day
or two. Literally, it means buying in the morning and selling in the afternoon. Day
trading became popular in the 1990s when stock prices were riding the tide of the
tech stock bubble. At that time it was possible to hold a stock for just a few hours
and earn a gain. Technology, especially the Internet, also made real-time quotes
and other market data available to individual investors at a reasonable cost. At the
same time, Internet and discount brokers drove down the costs of trading.
Day trading declined, but did not die, after the tech bubble burst. It turns out that
in a bubble, any strategy can make money, but when market volatility is more
closely related to earnings potential and fundamental value, there iis no shortcut to
doing your homework, knowing as much as possible about your investments, and
making appropriate strategic choices for you.
KEY TAKEAWAYS
• Common long-term strategies try to maximize returns by
◦ minimizing transaction costs or

◦ minimizing the effects of market timing.
• Long-term stock strategies include buy and hold, dollar-cost averaging,
direct investment, dividend reinvestment, and indexing.
• Common short-term strategies try to maximize return by taking
advantage of market timing.
39. A short-term strategy for

taking advantage of excessive
volatility.

EXERCISES
1. Review your investing horizon, risk tolerance, and needs. In My Notes or

your personal finance journal, record your ideas about the effects of
your horizon, risk profile, and personal circumstances on your decisions
about investing in stocks. Rank the long-term and short-term
investment strategies in order of their appropriateness for you. Explain
why your top-ranked strategies seem best for you at this time.
2. Survey (but do not join) Web sites for day traders online. Then read an
article for beginning day traders at http://www.investopedia.com/
articles/trading/06/DayTradingRetail.asp?viewed=1. What information
in this article do you find discouraging about getting involved in day
trading? Read the Securities and Exchange Commission’s (SEC) page on
day trading at http://www.sec.gov/answers/daytrading.htm. According
to the SEC, what regulatory rules would apply to you if you were
identified as a “pattern day trader”?

Chapter 16
Owning Bonds
Introduction
In common parlance, a bond is an affinity between people. In science, that affinity is

physically held together by an attraction of atoms. In finance, a bond is a debt
agreement, holding lender and borrower together in a shared financial fate.
Investors buy bonds to participate in economic growth as lenders rather than as

shareholders, with less risk and a firmer claim on assets. Bonds are issued by
different kinds of organizations—by governments and government agencies as well
as by corporations—giving investors different kinds of partners in growth.
Since bonds are a different form of capital than stocks, and since bond investments
are made in different kinds of borrowers, bonds offer diversification from the
stocks in your portfolio. Your use of bonds may change over time, as your risk
tolerance or liquidity needs change.
481
Chapter 16 Owning Bonds
16.1 Bonds and Bond Markets
LEARNING OBJECTIVES
1. Identify bond features that can determine risk and return.

2. Differentiate the roles of various U.S. government bonds.
3. List the types and features of state and municipal bonds.
4. Compare and contrast features of the corporate bond markets, the
markets for corporate stock, and the markets for government bonds.
5. Explain the role of rating agencies and the process of bond rating.
Bonds are a relatively old form of financing. Formalized debt arrangements long
preceded corporate structure and the idea of equity (stock) as we know it. Venice
issued the first known government bonds of the modern era in 1157,Isadore
Barmash, The Self-Made Man (Washington, DC: Beard Books, 2003), 55. while private
bonds are cited in British records going back to the thirteenth century.George
Burton Adams, The Constitutional History of England (London: H. Holt, 1921), 93.
Venice issued bonds to raise funds to finance a Crusade against Constantinople,
which included expansion of a shipyard attached to the Venetian Arsenal. (Go to
http://en.wikipedia.org/wiki/Venetian_Arsenal to view images.)
Bonds
In addition to financing government projects, bonds are used by corporations to

capitalize growth. Bonds are also a legal arrangement, couched in conditions,
obligations, and consequences. As a result of their legal and financial roles, bonds
carry a quaint and particular vocabulary. Bonds come in all shapes and sizes to suit
the needs of the borrowers and the demands of lenders. Figure 16.1 "Basic Bond
Features" lists the descriptive terms for basic bond features.
482
Figure 16.1 Basic Bond Features
1. The interest payment on a

bond, specified as a feature of
the bond at issuance.
2. For a bond, the amount to be

repaid to the bondholder upon
redemption.
3. The interest rate offered on a The coupon1 is usually paid to the investor twice yearly. It is calculated as a
bond. percentage of the face value2—amount borrowed—so that the annual coupon =
4. A benchmark interest rate coupon rate × face value. By convention, each individual bond has a face value of
understood to be the rate that $1,000. A corporation issuing a bond to raise $100 million would have to issue
major banks charge corporate 100,000 individual bonds (100,000,000 divided by 1,000). If those bonds pay a 4
borrowers with the least
default risk. percent coupon, a bondholder who owns one of those bonds would receive a coupon
of $40 per year (1,000 × 4%), or $20 every six months.
5. A bond that has a coupon rate
of zero, and therefore a coupon
of zero. Its only cash flow The coupon rate3 of interest on the bond may be fixed or floating and may change.
return is the principal
A floating rate is usually based on another interest benchmark, such as the U.S.
repayment at maturity.
prime rate4, a widely recognized benchmark of prevailing interest rates.
6. Bonds whose coupon payments
are deferred until a specified
time. A zero-coupon bond5 has a coupon rate of zero: it pays no interest and repays only
7. Deferred coupon bonds that
the principal at maturity. A “zero” may be attractive to investors, however, because
pay no interest for a specified it can be purchased for much less than its face value. There are deferred coupon
period, followed by higher- bonds6 (also called split-coupon bonds7 and issued below par), which pay no
than-normal interest payments interest for a specified period, followed by higher-than-normal interest payments
until maturity.
until maturity. There are also step-up bonds8 that have coupons that increase over
8. A bond with a floating-rate time.
coupon that is scheduled to
increase at specified intervals.
16.1 Bonds and Bond Markets 483

The face value, the principal amount borrowed, is paid back at maturity. If the bond
is callable9, it may be redeemed after a specified date but before maturity. A
borrower typically “calls” its bonds after prevailing interest rates have fallen,
making lower-cost debt available. Borrowers can borrow new, cheaper debt and pay
off the older, more expensive debt. As an investor (lender), you would be paid back
early, which sounds great, but because interest rates have fallen, you would have
trouble finding another bond investment that would pay as high a rate of return.
A convertible bond10 is a corporate bond that may be converted into common

equity at maturity or after some specified time. If a bond were converted into stock,
the bondholder would become a shareholder, assuming more of the company’s risk.
The bond may be secured by collateral, such as property or equipment, sometimes

9. A bond that may be redeemed called a mortgage bond11. If unsecured, or secured only by the “full faith and
before maturity. credit” of the borrower (the borrower’s unconditional commitment to pay principal
10. A bond that may be converted and interest on the debt), the bond is a debenture12. Most bonds are issued as
to common stock under debentures.
specific conditions.
11. A bond secured by a specific A bond specifies if the borrower has more than one bond issue outstanding or more
asset such as real property or
equipment. than one set of lenders to repay, which establishes the bond’s seniority in relation
to previously issued debt. This “pecking order” determines which lenders will be
12. A bond secured by only the paid back first in case of default on the debt or bankruptcy. Thus, when the
“full faith and credit” of the
borrower and not by any
borrower does not meet its coupon obligations, investors holding senior debt13 as
specific asset. opposed to subordinated debt14 have less risk of default.
13. A bond issue that has a

superior claim in case of Bonds may also come with covenants15 or conditions on the borrower. Covenants
bankruptcy.
are usually attached to corporate bonds and require the company to maintain
14. A bond issue that has an certain performance goals during the term of the loan. Those goals are designed to
inferior claim in case of lower default risk16 for the lender. Examples of typical covenants are
bankruptcy.
15. A condition of a loan that

restricts the borrower to
• dividend limits,
protect the lender. • debt limits,
• limits on sales of assets,
16. The risk that a borrower will
not be able to meet interest
• maintenance of certain liquidity ratios or minimum cash balances.
obligations or principal
repayment.
Corporations issue corporate bonds, usually with maturities of ten, twenty, or thirty
17. Bonds issued by the U.S. years. Corporate bonds tend to be the most “customized,” with features such as
government with a maturity of callability, conversion, and covenants.
less than one year.
18. Bonds issued by the U.S.

government with a maturity of The U.S. government issues Treasury bills17 for short-term borrowing, Treasury
between one and ten years. notes18 for intermediate-term borrowing (longer than one year but less than ten

years), and Treasury bonds19 for long-term borrowing for more than ten years. The
federal government also issues Treasury Inflation-Protected Securities (TIPS)20.
TIPS pay a fixed coupon, but the principal adjusts with inflation. At maturity, you
are repaid either the original principal or the inflation-adjusted principal,
whichever is greater.
State and municipal governments issue revenue bonds or general obligation bonds.
A revenue bond21 is repaid out of the revenue generated by the project that the
debt is financing. For example, toll revenue may secure a debt that finances a
highway. A general obligation bond22 is backed by the state or municipal
government, just as a corporate debenture is backed by the corporation.
Interest from state and municipal bonds23 (also called “munis”) may not be subject
to federal income taxes. Also, if you live in that state or municipality, the interest
may not be subject to state and local taxes. The tax exemption differs from bond to
bond, so you should be sure to check before you invest. Even if the interest is not
taxable, however, any gain (or loss) from the sale of the bond is taxed, so you should
not think of munis as “tax-free” bonds.
Foreign corporations and governments issue bonds. You should keep in mind,
however, that foreign government defaults are not uncommon. Mexico in 1994,
Russia in 1998, and Argentina in 2001 are all recent examples. Foreign corporate or
sovereign debt also exposes the bondholder to currency risk, as coupons and
principal will be paid in the foreign currency. Figure 16.2 "Bond Issuers and Terms"
19. Bonds issued by the U.S.
shows a summary of bonds and their issuers.
government with a maturity of
more than ten years.
20. Bonds issued by the U.S. Figure 16.2 Bond Issuers and Terms
government with an adjustable
face value designed to protect
the bondholder against
inflation risk.
21. A state or municipal bond that

will be repaid from revenues of
the specific project it is
financing.
22. A state or municipal bond

secured only by the “full faith
and credit” of the issuer.
23. Bonds issued by a city, town or

state to finance public projects.
The coupon payments may,
under certain circumstances,
not be subject to federal
income tax for the bondholder.

Bond Markets
The volume of capital traded in the bond markets is far greater than what is traded
in the stock markets. All sorts of borrowers issue bonds: corporations; national,
state and municipal governments; and government agencies. Even small towns
issue bonds to finance capital expenditures such as schools, fire stations, and roads.
Each kind of bond has its own market.
Private placement24 refers to bonds that are issued in a private sale rather than
through the public markets. The investors in privately placed bonds are
institutional investors such as insurance companies, endowments, and pension
funds.
U.S. Treasury bonds are issued to the primary market through auctions.
Participants, usually dealers or institutional investors, bid for the bonds, but no one
participant is allowed to buy enough shares to monopolize the secondary market.
Individuals can also buy Treasuries directly from the U.S. Treasury through its
online service, called TreasuryDirect
(http://www.treasurydirect.gov/).TreasuryDirect, http://www.treasurydirect.gov/
(accessed June 13, 2009).
Corporate bonds are traded in over-the-counter transactions through brokers and

dealers. Because the details of each bond issue may vary—maturity, coupon rate,
callability, convertibility, covenants, and so on—it is hard to directly compare bond
values the way stock values are compared. As a result, the corporate bond markets
are less transparent to the individual investor.
To provide guidance, rating agencies25 provide bond ratings; that is, they “grade”
individual bond issues based on the likelihood of default and thus the risk to the
investor. Rating agencies are independent agents that base their ratings on the
financial stability of the company, its business strategy, competitive environment,
outlook for the industry and the economy—any factors that may affect the
company’s ability to meet coupon obligations and pay back debt at maturity.
Ratings agencies such as Fitch Ratings, A. M. Best, Moody’s, and Standard & Poor’s
(S&P) are hired by large borrowers to analyze the company and rate its debt.
Moody’s also rates government debt. Ratings agencies use an alphabetical system to
24. An issuance of bonds through a grade bonds (shown in Figure 16.3 "Bond Ratings") based on the highest-to-lowest
private deal rather than rankings of two well-known agencies.
through the public markets.
25. Analysts of bond default risk

that assign ratings to bonds.

Figure 16.3 Bond Ratings
A plus sign (+) following a rating indicates that it is likely to be upgraded, while a
minus sign (−) following a rating indicates that it is likely to be downgraded.
Bonds rated BBB or Baa and above are considered investment grade bonds26,
relatively low risk and “safe” for both individual and institutional investors. Bonds
rated below BBB or Baa are speculative in that they carry some default risk. These
are called speculative grade bonds27, junk bonds28, or high-yield bonds29.
Because they are riskier, speculative grade bonds need to offer investors a higher
return or yield in order to be “priced to sell.”
26. Bonds rated BBB or Baa or Although the term “junk bonds” sounds derogatory, not all speculative grade bonds
higher and considered to carry are “worthless” or are issued by “bad” companies. Bonds may receive a speculative
insignificant default risk. rating if their issuers are young companies, in a highly competitive market, or
27. High yield bonds rated BB or capital intensive, requiring lots of operating capital. Any of those features would
Ba or lower and considered to make it harder for a company to meet its bond obligations and thus may consign its
have significant default risk. bonds to a speculative rating. In the 1980s, for example, companies such as CNN and
28. High yield bonds rated BB or MCI Communications Corporation issued high-yield bonds, which became lucrative
Ba or lower and considered to investments as the companies grew into successful corporations.
have significant default risk.
29. Bonds rated BB or Ba or lower, Default risk is the risk that a company won’t have enough cash to meet its interest
considered to have significant
default risk.
payments and principal payment at maturity. That risk depends, in turn, on the

company’s ability to generate cash, profit, and grow to remain competitive. Bond-
rating agencies analyze an issuer’s default risk by studying its economic, industry,
and firm-specific environments and estimate its current and future ability to satisfy
its debts. The default risk analysis is similar to equity analysis, but bondholders are
more concerned with cash flows—cash to pay back the bondholders—and profits
rather than profits alone.
Bond ratings can determine the coupon rate the issuer must offer investors to
compensate them for default risk. The higher the risk, the higher the coupon must
be. Ratings agencies have been criticized recently for not being objective enough in
their ratings of the corporations that hire them. Nevertheless, over the years bond
ratings have proven to be a reliable guide for bond investors.

KEY TAKEAWAYS
• Bond features that can determine risk and return include
◦ coupon and coupon structure,

◦ maturity, callablility, and convertibility,
◦ security or debenture,
◦ seniority or subordination,
◦ covenants.
• The U.S. government issues Treasury
◦ bills for short-term borrowing,

◦ notes for intermediate-term borrowing,
◦ bonds for long-term borrowing,
◦ TIPS, which are inflation-protected.
• State and municipal governments issue
◦ revenue bonds, secured by project revenues, or

◦ general obligation bonds, secured by the government issuer.
• State and municipal government muni bonds may or may not have tax
advantages for certain investors.
• Corporate bonds may be issued through the public bond markets or
through private placement.
• U.S. government bonds are issued through auctions managed by the
Federal Reserve.
• The secondary bond market offers little transparency because of the
differences among bonds and the lower volume of trades.
• To help provide transparency, rating agencies analyze default risk and
rate specific bonds.

EXERCISES
1. Explore the homepages of S&P at http://www2.standardandpoors.com/

portal/site/sp/en/us/page.home/home/
0,0,0,0,0,0,0,0,0,0,0,0,0,0,0,0.html and Moody’s at
http://www.moodys.com. Access to bond ratings at these sites requires
registration, but other information is readily available. For example,
how does S&P explain that its rating system does not directly measure
default risk? Next, read Moody’s explanation of its performance as a
rating agency at http://www.moodys.com/cust/content/
content.ashx?source= StaticContent/Free%20pages/
Credit%20Policy%20Research/documents/current/
2001700000407258.pdf. What do the data generally show about the
relationship between ratings and defaults on corporate bonds? What
examples of defaults on municipal bonds does Moody’s give as examples
of the effects of financial stress on city governments? According to
Moody’s, how do municipal bonds compare to corporate bonds as
investments? To find more information about bonds and investor tools
for choosing bonds and calculating bond value, go to
http://www.bondsonline.com.
2. What is your state’s bond rating? A keyword search (“[state name] bond
rating”) will bring up current articles on this subject in the news media.
What state government activities or expenditures do the bond issues
finance? What factors have caused your state’s bond rating to be
increased or decreased recently? How does your state’s bond rating
compare with ratings of other states in your region? Now find the
current bond rating for your city or town. In My Notes or your personal
finance journal, write an explanation of why you might or might not
invest in your city or town and state at this time. In general, why might
you want to invest in municipal bonds? What role would bonds play in
your investment portfolio?

16.2 Bond Value
LEARNING OBJECTIVES
1. Explain how bond returns are measured.

2. Define and describe the relationships between interest rates, bond
yields, and bond prices.
3. Define and describe the risks that bond investors are exposed to.
4. Explain the implications of the three types of yield curves.
5. Assess the role of the yield curve in bond investing.
Bond-rating systems do not replace bond analysis, which focuses on bond value.
Like any investment, a bond is worth the value of its expected return. That value
depends on the amount expected and the certainty of that expectation. To
understand bond values, then, is to understand the value of its return and the costs
of its risks.
Bonds return two cash flows to their investors: (1) the coupon, or the interest paid
at regular intervals, usually twice yearly or yearly, and (2) the repayment of the
principal at maturity. The amounts are spelled out in the bond itself. The coupon
rate is specified (for a fixed-rate bond) and the face value is the principal to be
returned at the stated maturity.
Unlike a stock, for which the cash flows—both the amount and the timing—are “to
be determined,” in a bond everything about the cash flows is established at the
outset. Any bond feature that makes those cash flows less certain increases the risk
to the investor and thus the investor’s return. If the bond has a floating-rate
coupon, for example, then there is uncertainty about the amount of the coupon
payments. If the bond is callable, there is uncertainty about the number of coupon
payments.
Whatever the particular features of a bond, as debt instruments, bonds expose

investors to specific risks. What are those risks, and what is their role is defining
expectations of returns?
491
Bond Returns
Unlike a stock, a bond’s future cash returns are known with certainty. You know
what the coupon will be (for a fixed-rate bond) and you know that at maturity the
bond will return its face value. For example, if a bond pays a 4 percent coupon and
matures in 2020, you know that every year your will receive $20 twice per year (20 =
4% × 1,000 × ½) until 2020 when you will also receive the $1,000 face value at
maturity. You know what you will get and when you will get it. However, you can’t
be sure what that will be worth to you when you do. You don’t know what your
opportunity cost will be at the time.
Investment returns are quoted as an annual percentage of the amount invested, the
rate of return. For a bond, that rate is the yield. Yield is expressed in two ways: the
current yield and the yield to maturity. The current yield30 is a measure of your
bond’s rate of return in the short term, if you buy the bond today and keep it for
one year. You can calculate the current yield by looking at the coupon for the year
as a percentage of your investment or the current price, which is the market price
of the bond.
current yield = annual coupon (interest received, or cash flows) ÷ market value =
(coupon rate × face value) ÷ market value.
So, if you bought a 4 percent coupon bond, which is selling for $960 today (its
market value), and kept it for one year, the current yield would be 40 (annual
coupon) ÷ 960 (market value) = 4.1667%. The idea of the current yield is to give you a
quick look at your immediate returns (your return for the next year).
In contrast, the yield to maturity31 (YTM) is a measure of your return if you bought
the bond and held it until maturity, waiting to claim the face value. That calculation
is a bit more complicated, because it involves the relationship between time and
value (Chapter 4 "Evaluating Choices: Time, Risk, and Value"), since the yield is over
the long term until the bond matures. You will find bond yield-to-maturity
calculators online, and many financial calculators have the formulas
preprogrammed.
30. The short-term return on a

To continue the example, if you buy a bond for $960 today (2010), you will get $20
bond, calculated as the coupon
as a percentage of the bond every six months until 2020, when you will also get $1,000. Because you are buying
price. the bond for less than its face value, your return will include all the coupon
payments ($400 over 10 years) plus a gain of $40 (1,000 − 960 = 40). Over the time
31. The total return on a bond,
assuming it is held to maturity until maturity, the bond returns coupons plus a gain. Its yield to maturity is close to
and that coupons may be 4.5 percent.
reinvested at the same rate.
16.2 Bond Value 492

Bond prices, their market values, have an inverse relationship to the yield to
maturity. As the price goes down, the yield goes up, and as the price goes up, the
yield goes down. This makes sense because the payout at maturity is fixed as the
face value of the bond ($1,000). Thus, the only way a bond can have a higher rate of
return is to have a lower price in the first place.
The yield to maturity is directly related to interest rates in general, so as interest

rates increase, bond yields increase, and bond prices fall. As interest rates fall, bond
yields fall, and bond prices increase. Figure 16.4 "Bond Prices, Bond Yields, and
Interest Rates" shows these relationships.
Figure 16.4 Bond Prices, Bond Yields, and Interest Rates
You can use the yield to maturity to compare bonds to see how good they are at
creating returns. This yield holds if you hold the bond until maturity, but you may
sell the bond at any time. When you sell the bond before maturity, you may have a
gain or a loss, since the market value of the bond may have increased or decreased
since you bought it. That gain or loss would be part of your return along with the
coupons you have received over the holding period, the period of time that you
held the bond.
16.2 Bond Value 493

Your holding period yield32 is the annualized rate of return that you receive
depending on how long you have held the bond, its gain or loss in market value, and
the coupons you received in that period. For example, if you bought the bond for
$960 and sold it again for $980 after two years, your return in dollars would be the
coupons of $80 ($40 per year × 2 years) plus your gain of $20 ($980 − 960), relative to
your original investment of $960. Your holding period yield would be close to 5.2
percent.
Bond Risks
The basic risk of bond investing is that the returns—the coupon and the principal
repayment (face value)—will not be repaid, or that when they are repaid, they won’t
be worth as much as you thought they would be. The risk that the company will be
unable to make its payments is default risk—the risk that it will default on the bond.
You can estimate default risk by looking at the bond rating as well as the economic,
sector, and firm-specific factors that define the company’s soundness.
Part of a bond’s value is that you can expect regular coupon payments in cash. You
could spend the money or reinvest it. There is a risk, however, that when you go to
reinvest the coupon, you will not find another investment opportunity that will pay
as high a return because interest rates and yields have fallen. This is called
reinvestment risk33. Your coupons are the amount you thought they would be, but
they are not worth as much as you expected, because you cannot earn as much from
them.
If interest rates and bond yields have dropped, your fixed-rate bond, which is still
paying the now-higher-than-other-bonds coupon, has become more valuable. Its
market price has risen. But the only way to realize the gain from the higher price is
32. The annualized return on a to sell the bond, and then you won’t have any place to invest the proceeds in other
bond over the period it is bonds to earn as much return.
owned.
33. The risk that a change in

Reinvestment risk is one facet of interest rate risk, which arises from the
interest rates during the
bond’s term will change the fundamental relationship between bond values and interest rates. Interest rate
earnings from reinvesting risk34 is the risk that a change in prevailing interest rates will change bond
bond coupons. value—that interest rates will rise and the market value of the bond will fall. (If
34. The risk that a bond’s market interest rates fell, the bond value would increase, which the investor would not see
value will be affected by a as a risk.)
change in interest rates.
35. The risk that the value of a Another threat to the value of your coupons and principal repayment is inflation.
bond’s returns will be
decreased by a decrease in
Inflation risk35 is the risk that your coupons and principal repayment will not be
value of the currency of the worth as much as you thought, because inflation has decreased the purchasing
bond’s denomination. power or the value of the dollars you receive.
16.2 Bond Value 494

A bond’s features can make it more or less vulnerable to these risks. In general, the
longer the term to maturity is, the riskier the bond is. The longer the term is, the
greater the probability that the bond will be affected by a change in interest rates, a
period of inflation, or a damaging business cycle.
In general, the lower the coupon rate and the smaller the coupon, the more
sensitive the bond will be to a change in interest rates. The lower the coupon rate
and the smaller the coupon, the more of the bond’s return comes from the
repayment of principal, which only happens at maturity. More of your return is
deferred until maturity, which also makes it more sensitive to interest rate risk. A
bond with a larger coupon provides more liquidity, over the term of the bond, and
less exposure to risk. Figure 16.5 "Bond Characteristics and Risks" shows the
relationship between bond characteristics and risks.
Figure 16.5 Bond Characteristics and Risks
A zero-coupon bond offers the lowest coupon rate possible: zero. Investors avoid
reinvestment risk since the only return—and reinvestment opportunity—comes
when the principal is returned at maturity. However, a “zero” is exposed to the
maximum interest rate risk, because interest rates will always be higher than its
16.2 Bond Value 495

coupon rate of zero. The attraction of a zero is that it can be bought for a very low
price.
As a bond investor, you can make better decisions if you understand how the
characteristics of bonds affect their risks and yields as you use those yields to
compare and choose bonds.
Yield Curve
Interest rates affect bond risks and bond returns. If you plan to hold a bond until
maturity, interest rates also affect reinvestment risk. If you plan to sell the bond
before maturity, you face interest rate risk or the risk of a loss of market value.
When you invest in bonds, then, you want to be able to forecast future interest
rates.
Investors can get a sense of how interest rates are expected to change in the future
by studying the yield curve. The yield curve36 is a graph of U.S. Treasury securities
compared in terms of the yields for bonds of different maturities. U.S. Treasury
securities are used because the U.S. government is considered to have no default
risk, so that the yields on its bills and bonds reflect only interest rate, reinvestment,
and inflation risks—all of which are reflected in expected, future interest rates.
The yield curve illustrates the term structure of interest rates37, or the
relationship of interest rates to time. Usually, the yield curve is upward
sloping—that is, long-term rates are higher than short-term rates. Long-term rates
indicate expected future rates. If the economy is expanding, future interest rates
are expected to be higher than current interest rates, because capital is expected to
be more productive in the future. Future interest rates will also be higher if there is
inflation because lenders will want more interest to make up for the fact that the
currency has lost some of its purchasing power. Figure 16.6 "Upward-Sloping Yield
Curve" shows an upward-sloping yield curve.
36. A graphic depiction of the term

structure of interest rates.
37. A comparison of interest rates

for bonds of different
maturities.
16.2 Bond Value 496

Figure 16.6 Upward-Sloping Yield CurveU.S. Department of the Treasury, “Daily Treasury Yield Curve Rates,”
http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/
TextView.aspx?data=yieldYear&year=2007 (accessed May 23, 2012).
Depending on economic forecasts, the yield curve can also be flat, as in Figure 16.7
"Flat Yield Curve", or downward sloping, as in Figure 16.8 "Downward-Sloping Yield
Curve".
16.2 Bond Value 497

Figure 16.7 Flat Yield CurveU.S. Department of the Treasury, “Daily Treasury Yield Curve Rates,”
http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/
16.2 Bond Value 498

Figure 16.8 Downward-Sloping Yield CurveU.S. Department of the Treasury, “Daily Treasury Yield Curve
Rates,” http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/
A flat yield curve indicates that future interest rates are expected to be about the
same as current interest rates or that capital will be about as productive in the
economy as it is now. A downward-sloping yield curve shows that future interest
rates are expected to be lower than current rates. This is often interpreted as a
signal of a recession, because capital would be less productive in the future if the
economy were less productive then.
The yield curve is not perfectly smooth; it changes every day as bonds trade and
new prices and new yields are established in the bond markets. It is a widely used
indicator of interest rate trends, however. It can be useful to you to know the broad
trends in interest rates that the market sees.
For your bond investments, an upward-sloping yield curve indicates that interest
rates will go up, which means that bond yields will go up but bond prices will go
down. If you are planning to sell your bond in that period of rising interest rates,
you may be selling your bond at a loss.
16.2 Bond Value 499

Because of their known coupon and face value, many investors use bonds to invest
funds for a specific purpose. For example, suppose you have a child who is eight
years old and you want her to be able to go to college in ten years. You might invest
in bonds that have ten years until maturity. However, if you invest in bonds that
have twenty years until maturity, they will have a higher yield (all else being equal),
so you could invest less now.
You could buy the twenty-year bonds but plan to sell them before maturity for a
price determined by what interest rates are in ten years (when you sell them). If the
yield curve indicates that interest rates will rise over the next ten years, then you
could expect your bond price to fall, and you would have a loss when you sell the
bond, which would take away from your returns.
In general, rising interest rates mean losses for bondholders who sell before
maturity, and falling interest rates mean gains for bondholders who sell before
maturity. Unless you are planning to hold bonds until maturity, the yield curve can
give you a sense of whether you are more likely to have a gain or loss.
16.2 Bond Value 500

KEY TAKEAWAYS
• All bonds expose investors to
◦ default risk (the risk that coupon and principal payments

won’t be made),
◦ reinvestment risk (the risk that coupon payments will be
reinvested at lower rates),
◦ interest rate risk (the risk that changing interest rates will
affect bond values),
◦ inflation risk, (the risk that inflation will devalue bond
coupons and principal repayment).
• Bond returns can be measured by yields.
◦ The current yield measures short-term return on

investment.
◦ The yield to maturity measures return on investment until
maturity.
◦ The holding period yield measures return on investment
over the term that the bond is held.
• There is a direct relationship between interest rates and bond yields.
• There is an inverse relationship between bond yields and bond prices
(market values).
• There is an inverse relationship between bond prices (market values)
and interest rates.
• The yield curve illustrates the term structure of interest rates, showing
yields of bonds with differing maturities and the same default risk. The
purpose of a yield curve is to show expectations of future interest rates.
• The yield curve may be
◦ upward sloping, indicating higher future interest rates;

◦ flat, indicating similar future interest rates; or
◦ downward sloping, indicating lower future interest rates.
16.2 Bond Value 501

EXERCISES
1. How do you buy bonds? Read Investopedia’s primer at

http://www.investopedia.com/university/bonds/bonds6.asp. What is
the minimum investment for bonds? What is the difference between
investing in bonds and investing in a bond fund? Read eHow’s
explanation of how to buy bonds online at http://www.ehow.com/
how_3294_buy-bonds-online.html.
2. Read Investopedia’s explanation of how to read a bond table at
http://www.investopedia.com/university/bonds/bonds5.asp. In the
example of a bond table, suppose you invested $5,000 in Avco’s bond
issue. What coupon rate were you getting? When was the maturity date,
and how much did you get then? What was the current value of the bond
at that time? What does it mean for a bond to be trading above par?
What was the bond’s annual return during the time you held it? If you
held the bond for ten years, what cash flows did you receive? Would you
have reinvested in the bond when it matured, or would you have sold it
and why? Study the other corporate bonds listed in the Investopedia
example of a bond table. If in 2005 you had $5,000 to invest in bonds,
which issuing company would you have chosen and why?
3. To find out more about how to use bond tables when making investment
decisions, go to http://www.investinginbonds.com/
learnmore.asp?catid=3&id=45. Where will you find bond tables? What
will you compare in bond tables? At the top of this Securities Industry
and Financial Markets Association (SIFMA) page, click on one of the
bond markets “at-a-glance” under “Bond Markets & Prices.” Then enter
the name of an issuer on the form and choose the data you want to see.
For example, enter your state’s name and ask to see all the bonds by
yield or by maturity date or by some other search factor. What do these
data tell you? For each search factor, how would the information assist
you in making decisions about including bonds in your investment
portfolio?
4. Experiment with Investopedia’s yield-to-maturity calculator at
http://www.investopedia.com/calculator/AOYTM.aspx. Try other
calculators as well, such as the one at http://www.mahalo.com/how-do-
i-calculate-yield-to-maturity-on-bonds. Why should you know the yield
to maturity, indicated as YTM on the calculator, before investing in
bonds?
16.2 Bond Value 502

16.3 Bond Strategies
LEARNING OBJECTIVES
1. Discuss diversification as a strategic use of bonds.

2. Summarize strategies to achieve bond diversification.
3. Define and compare matching strategies.
4. Explain life cycle investing and bond strategy.
Bonds provide more secure income for an investment portfolio, while stocks
provide more growth potential. When you include bonds in your portfolio, you do
so to have more income and less risk than you would have with just stocks. Bonds
also diversify the portfolio. Because debt is so fundamentally different from equity,
debt markets and equity markets respond differently to changing economic
conditions.
Diversification Strategies
If your main strategic goal of including bonds is diversification, you can choose an
active or passive bond selection strategy. As with equities, an active strategy
requires individual bond selection, while a passive strategy involves the use of
indexing, or investing through a broadly diversified bond index fund or mutual
fund in which bonds have already been selected.
The advantage of the passive strategy is its greater diversification and relatively
low cost. The advantage of an active strategy is the chance to create gains by
finding and taking advantage of market mispricings. An active strategy is difficult
for individual investors in bonds, however, because the bond market is less
transparent and less liquid than the stock market.
If your main strategic goal of including bonds is to lower the risk of your portfolio,
you should keep in mind that bond risk varies. U.S. Treasuries have the least default
risk, while U.S. and foreign corporate bonds have the most. Bond ratings can help
38. A difference between two you to compare default risks.
interest rates, quoted in basis
points. The most commonly
noted spreads are those Another way to look at the effect of default risk on bond prices is to look at spreads.
between Treasury and A spread38 is the difference between one rate and another. With bonds, the spread
corporate securities of the generally refers to the difference between one yield to maturity and another.
same maturity.
503
Spreads are measured and quoted in basis points. A basis point39 is one one-
hundredth of one percent, or 0.0001 or 0.01 percent.
The most commonly quoted spread is the difference between the yield to maturity
for a Treasury bond and a corporate bond with the same term to maturity. Treasury
bonds are considered to have no default risk because it is unlikely that the U.S.
government will default. Treasuries are exposed to reinvestment, interest rate, and
inflation risks, however.
Corporate bonds are exposed to all four types of risk. So the difference between a
twenty-year corporate bond and a twenty-year Treasury bond is the difference
between a bond with and without default risk. The difference between their
yields—the spread—is the additional yield for the investor for taking on default risk.
The riskier the corporate bond is, the greater the spread will be.
Spreads generally fluctuate with market trends and with confidence in the economy
or expectations of economic cycles. When spreads narrow, the yields on corporate
bonds are closer to the yields on Treasuries, indicating that there is less concern
with default risk. When spreads widen—as they did in the summer and fall of 2008,
when the debt markets seemed suddenly very risky—corporate bondholders worry
more about default risk.
As the spread widens, corporate yields rise and/or Treasury yields fall. This means
that corporate bond prices (market values) are falling and/or Treasury bond values
are rising. This is sometimes referred to as the “flight to quality.” In uncertain
times, investors would rather invest in Treasuries than corporate bonds, because of
the increased default risk of corporate bonds. As a result, Treasury prices rise (and
yields fall) and corporate prices fall (and yields rise).
Longer-term bonds are more exposed to reinvestment, interest rate, and inflation
risk than shorter-term bonds. If you are using bonds to achieve diversification, you
want to be sure to be diversified among bond maturities. For example, you would
want to have some bonds that are short-term (less than one year until maturity),
intermediate-term (two to ten years until maturity), and long-term (more than ten
years until maturity) in addition to diversifying on the basis of industries and
company and perhaps even countries.
39. A unit of measure that is one
one-hundredth of a percentage
point, or 0.01 percent. Matching Strategies
40. Strategies used to create a
bond portfolio that will finance Matching strategies40 are used to create a bond portfolio that will finance specific
specific funding or liquidity
funding needs, such as education, a down payment on a second home, or
needs at specific times.
16.3 Bond Strategies 504

retirement. If the timing and cash flow amounts of these needs can be predicted,
then a matching strategy can be used to support them. This strategy involves
matching a “liability” (to yourself, because you “owe” yourself the chance to reach
that goal) with an asset, a bond investment. The two most commonly used matching
strategies are immunization and cash flow matching.
Immunization41 is designing a bond portfolio that will achieve a certain rate of

return over a specific period of time, based on the idea of balancing interest rate
risk and reinvestment risk.
Recall that as interest rates rise, bond values decrease, but reinvested income from
bond coupons earns more. As interest rates fall, bond values increase, but
reinvested income from bond coupons decreases. Immunization is the idea of
choosing a portfolio of bonds such that the exposure to interest rate risk is exactly
offset by the exposure to reinvestment risk for a certain period of time, thus
guaranteeing a minimum return over that period.John L. Maginn, Donald L. Tuttle,
Jerald E. Pinto, and Dennis W. McLeavey, eds., Managing Investment Portfolios: A
Dynamic Process, 3rd ed. (Charlottesville, VA: CFA Institute, 2007).
In other words, the interest rate risk and the reinvestment risk cancel each other
out, and the investor is left with a guaranteed return. You would use this kind of
strategy when you had a liquidity need with a deadline, for example, to fund a
child’s higher education.
Cash flow matching42, also called a dedication strategy, is an alternative to

immunization. It involves choosing bonds that match your anticipated cash flow
needs by having maturities that coincide with the timing of those needs. For
example, if you will need $50,000 for travel in twenty years, you could buy bonds
with a face value of $50,000 and a maturity of twenty years. If you hold the bonds to
maturity, their face value provides the amount of cash flow you need, and you don’t
have to worry about interest rate or reinvestment risk. You can plan on having
$50,000 in twenty years, barring any default.
If you had the $50,000 now, you could just stuff it under your mattress or save it in a
savings account. But buying a bond has two advantages: (1) you may be able to buy
41. A bond portfolio strategy the bond for less than $50,000 now, requiring less upfront investment and (2) over
designed to “immunize” or
the next twenty years, the bond will also pay coupons at a higher rate than you
protect the portfolio from
interest rate risk. could earn with a savings account or under your mattress.
42. A strategy of investing in

bonds with maturities and face If you will need different cash flows at different times, you can use cash flow
values that match anticipated matching for each one. When cash flow matching is used to create a steady stream
cash flow amounts and timing.

of regular cash flows, it is called bond laddering43. You invest in bonds of different
maturities, such that you would have one bond maturing and providing cash flow in
each period (like the CD laddering discussed in Chapter 7 "Financial Management").
Strategies such as immunization and cash flow matching are designed to manage
interest rate and reinvestment risk to minimize their effects on your portfolio’s
goals. Since you are pursuing an active strategy by selecting individual bonds, you
must also consider transaction costs and the tax consequences of your gain (or loss)
at maturity and their effects on your target cash flows.
Life Cycle Investing
Bonds most commonly are used to reduce portfolio risk. Typically, as your risk
tolerance decreases with age, you will include more bonds in your portfolio, shifting
its weight from stocks—with more growth potential—to bonds, with more income
and less risk. This change in the weighting of portfolio assets usually begins as you
get closer to retirement.
For years, the conventional wisdom was that you should have the same percentage
of your portfolio invested in bonds as your age, so that when you are thirty, you
have 30 percent of your portfolio in bonds; when you are fifty, you have 50 percent
of your portfolio in bonds, and so on. That wisdom is being questioned now,
however, because while bonds are lower risk, they also lower growth potential.
Today, since more people can expect to live much longer past retirement age, they
run a real risk of outliving their funds if they invest as conservatively as the
conventional wisdom suggests.
It is still true nevertheless that for most people, risk tolerance changes with age,
and your investment in bonds should reflect that change.
43. A strategy of cash flow

matching to create a series of
regular cash flows from bond
investments.

KEY TAKEAWAYS
• One strategic use of bonds in a portfolio is to increase diversification.
• Diversification can be achieved
◦ by an active strategy, using individual bond selection; or

◦ by a passive strategy, using indexing.
• Spreads indicate the “price” or the yield on default risk.
• Matching strategies to minimize interest rate and reinvestment

risks can include
◦ immunization,
◦ cash flow matching,
◦ bond laddering.
• Life cycle investing considers the relationship of age and risk tolerance
to the strategic use of bonds in a portfolio.
EXERCISES
1. In My Notes or your personal finance journal, record your bond

strategy. What will be your purpose in including bonds in your
portfolio? What types of bonds will you include and why? Will you take
an active or passive approach and why? How will spreads inform your
investment decisions? Which bond strategies described in this section
will you plan to use and why? How will your bond strategies reflect your
needs to diversify, reduce risk, and maximize liquidity at the right
times? How will your bond strategies reflect your age and risk
tolerance?
2. View the video “Investment Bond Basics” at http://www.videojug.com/
interview/investment-bond-basics. Discuss with classmates how this
video serves as a review of the information in this chapter. As part of
your review, brainstorm additional questions about bond investing to
ask the expert.

Chapter 17
Investing in Mutual Funds, Commodities, Real Estate, and
Collectibles
Introduction
When people think of investing, they tend to think of stocks and bonds, investing in
companies that create productivity, employment, and profit. Investments in stocks
and bonds are ways of sharing in that profit and ultimately in economic growth.
While companies are the engines of economic growth, other assets such as real
estate and commodities—natural resources or raw materials—fuel those engines.
Increased market transparency and access, largely through the technologies of the
Internet and global communications, have made it possible for more investors to
invest in the “fuels” as well as the “engines” of commerce. Real estate and
commodities investing have become increasingly popular as diversifiers for a sound
investment portfolio.
Mutual funds are not another kind of asset but another way of investing in any kind
of asset. The fund is a pool capable of much greater diversification than an
individual’s investment portfolio, given transaction costs. A mutual fund can also
provide security selection, expertise, liquidity, and convenience. Some funds are
even designed to perform the asset allocation task for the investor. Mutual funds
are fast becoming the dominant investment vehicle for individual investors,
changing the role of the broker and financial advisor.
508
Chapter 17 Investing in Mutual Funds, Commodities, Real Estate, and Collectibles
17.1 Mutual Funds
LEARNING OBJECTIVES
1. Identify the general purposes of using mutual funds in individual

investment portfolios.
2. Analyze the advantages of an index fund or a fund of funds.
3. List and define the structures of mutual funds.
4. Describe the strategic goals of lifestyle funds, leveraged funds, and
inverse funds.
5. Identify the costs and differences in costs of mutual fund investing.
6. Calculate returns from mutual fund investing.
7. Summarize the information found in a mutual fund prospectus.
As defined in the Chapter 12 "Investing", a mutual fund is a portfolio of securities,

consisting of one type of security or a combination of several different types. A fund
serves as a convenient way for an investor to have a diversified portfolio of
investments in just about any investable asset. The oldest mutual fund is believed to
have been founded by Adriaan van Ketwich in 1774. Ketwich invited investors to
contribute to a trust fund to spread the risk of investing in foreign bonds. The idea
moved from the Netherlands to Scotland to the United States, where the Boston
Personal Property Trust established the first mutual fund in
1893.FinanceScholar.com, http://www.financescholar.com/history-mutual-
funds.html (accessed June 15, 2009).
The mutual fund’s popularity has grown in periods of

economic expansion. At the height of the stock market Figure 17.1
boom in 1929, there were over seven hundred mutual
funds in the United States. After 1934, mutual funds fell
under the regulatory eye of the Securities and Exchange
Commission (SEC), and it wasn’t until the 1950s that
there were once again over one hundred mutual funds
in the United States.
Mutual funds multiplied in the 1970s, spurred on by the © 2010 Jupiterimages

Corporation
creation of IRAs and 401(k) retirement plans, and again
in the 1980s and 1990s, inspired by economic growth
and the tech stock boom. By the end of 2008, U.S.
mutual funds—which account for just over half of the
509
global market—had $9.6 trillion in assets under management. Forty-five percent of

all U.S. households owned mutual funds, compared to 6 percent in 1980. For 69
percent of those households, mutual funds were more than half of their financial
assets.The Investment Company Institute, 2009 Investment Company Fact Book, 49th
ed., 2009, http://www.ici.org/pdf/2009_factbook.pdf (accessed June 15, 2009).
Mutual funds play a significant role in individual investment decisions.
A mutual fund provides an investor with cheaper and simpler diversification and
security selection, requiring only one transaction to own a diversified portfolio (the
mutual fund). By buying shares in the fund rather than individual securities, you
achieve extensive diversification for a much lower transaction cost than by
investing in individual securities and making individual transactions. You also
receive the benefit of professional security selection, which theoretically minimizes
the opportunity costs of lesser choices. So by using a mutual fund, you get more and
better security selection and diversification.
A mutual fund also provides stock and bond issuers with a mass market. Rather
than selling shares to investors individually (and incurring the costs of doing so),
issuers can more easily find a market for their shares in mutual funds.
Structures and Types of Mutual Funds
Like stocks and bonds, mutual funds may be actively or passively managed. As you
read in Chapter 15 "Owning Stocks" and Chapter 16 "Owning Bonds", actively
managed funds provide investors with professional management and the expected
research, analysis, and watchfulness that goes with it. Passively managed index
funds1, on the other hand, are designed to mirror the performance of a specific
index constructed to be representative of an asset class. Recall, for example, that
the Standard & Poor’s (S&P) 500 Index is designed to mirror the performance of the
five hundred largest large cap stocks in the United States.
Mutual funds are structured in three ways:
1. Closed-end funds
1. A mutual fund designed to 2. Open-end funds
track the performance of an 3. Exchange-traded funds
index for investors who seek
diversification without having
to select securities.
Closed-end funds2 are funds for which a limited number of shares are issued. Once
2. A mutual fund that issues a all shares have been issued, the fund is “closed” so a new investor can only buy
limited number of shares, so shares from an existing investor. Since the shares are traded on an exchange, the
that existing shares must be
sold to new investors.
17.1 Mutual Funds 510

limited supply of shares and the demand for them in that market directly
determines the value of the shares for a closed-end fund.
Most mutual funds are open-end funds3 in which investors buy shares directly
from the fund and redeem or sell shares back to the fund. The price of a share is its
net asset value (NAV)4, or the market value of each share as determined by the
fund’s assets and liabilities and the number of shares that exist. Here is the basic
formula for calculating NAV:
NAV = (market value of fund securities − fund liabilities) ÷ number of shares

outstanding.
Demand for shares is reflected in the number of shares outstanding, because the
fund can create new shares for new investors. NAV calculations are usually done
once per day at the close of trading, when mutual fund transactions are recorded.
The NAV is the price that the fund will pay you when you redeem your shares, so it
is a gauge of the shares’ value. It will increase if the market value of the securities in
the fund increases faster than the number of new shares.
Exchange-traded funds (ETFs)5 are structured like closed-end funds but are traded
like stocks. Shares are traded and priced continuously throughout the day’s trading
session, rather than once per day at the end of trading. ETFs trade more like
individual securities; that is, if you are trying to time a market, they are a more
nimble asset to trade than open-end or closed-end funds.
Originally designed as index funds, exchange-traded funds now target just about
every asset, sector, and economic region imaginable. Because of this, ETFs have
3. A mutual fund in which shares become quite popular, with over $529 billion invested in over seven hundred funds
are bought from and sold to (as of April 2009).The Investment Company Institute, 2009 Investment Company Fact
the fund management; the
number of shares is not
Book, 49th ed., 2009, http://www.ici.org/pdf/2009_factbook.pdf (accessed June 15,
limited. 2009). Figure 17.2 "Fund Features" compares the features of closed-end funds, open-
end funds, and ETFs.
4. When used regarding open-end
mutual funds, NAV refers to
the redeemable value of each
fund share at that time, given
the market value of the fund’s
assets and the number of
shares outstanding.
5. A mutual fund that is

structured as a closed-end fund
and actively traded on an
exchange.

Figure 17.2 Fund Features
Shares of closed-end funds and exchange-traded funds are bought and sold on
exchanges, much like shares of stock. You would go through a broker to make those
transactions. Shares of open-end funds may be bought and sold directly from the
fund sponsor, a mutual fund company or investment manager such as Fidelity,
Vanguard, Janus, T. Rowe Price, or Teachers Insurance and Annuity Association-
College Retirement Equities Fund (TIAA-CREF). You can make those transactions at
any of the company’s offices, by telephone, or online. About 40 percent of all mutual
fund transactions are done directly (without a broker) through a retirement plan
contribution or a mutual fund company.The Investment Company Institute, 2009
Investment Company Fact Book, 49th ed., 2009, http://www.ici.org/pdf/
2009_factbook.pdf (accessed June 15, 2009).
Some other types of mutual funds are shown in Table 17.1 "Other Types of Mutual
Funds". Some research companies, such as Morningstar, track as many as forty-
eight different categories of mutual funds.
Table 17.1 Other Types of Mutual Funds
Mutual funds that own shares in other mutual funds rather than in specific
Funds of
securities. If you decide to use mutual funds rather than select securities, a
funds6
fund of funds will provide expertise in choosing funds.
Funds of stocks and bonds that manage portfolio risk based on age or the time
horizon for liquidity needs. Lifestyle funds perform both security selection
and asset allocation for investors, determined by the target date. For example,
6. A mutual fund that invests in Lifestyle if you were now thirty years old, you might choose a lifestyle fund with a
shares of other mutual funds funds7 target date of thirty-five years from now for your retirement savings. As the
rather than in specific securties.
fund approaches its target date, its allocation of investments in stocks and
7. A mutual fund designed to bonds will shift to carry less risk as the target nears. Lifestyle funds are used
perform asset allocation and primarily in saving for retirement; many are created as funds of funds.
security selection for the investor.
Assets are reallocated based on the
firm’s expected liquidity target
date.

Funds that invest both investors’ money and money that the fund borrows to
Leveraged
augment the investable assets and thus potential returns. Because they use
funds8
borrowing, leveraged funds are riskier than funds that do not use leverage.
Funds that aim to increase in value when the market declines, to be

countercyclical to index funds, which aim to increase in value when the
Inverse market rises. Inverse funds, also called bear funds, are set up to perform
funds9 contrary to the index. Since most economies become more productive over
time, however, you can expect indexes to rise over time, so an inverse fund
would make sense only as a very short-term investment.
Mutual Fund Fees and Returns
All funds must disclose their fees to potential investors: sales fees, management
fees, and expenses. A load fund10 charges a sales commission on each share
8. A mutual fund that invests purchase. That sales charge (also called a front-end load11) is a percentage of the
borrowed funds as well as purchase price. A no-load fund12, in contrast, does not charge a sales commission,
investors’ funds.
because shares may be purchased directly from the fund or through a discount
9. A mutual fund that aims to broker. The front-end load can be as much as 8.5 percent, so if you plan to invest
increase in value when the market
declines, in contrast to an index often or in large amounts, that can be a substantial charge. For example, a $5,000
fund, which aim to increase in investment may cost you $425, reducing the amount you have to invest and earn a
value when the market rises.
return.
10. A mutual fund that charges a
sales commission or fee upon
investment or purchase of A fund may charge a back-end load13, actually a deferred sales charge, paid when
shares; the load is stated as a you sell your shares instead of when you buy them. The charge may be phased out if
percentage of invested funds.
you own the shares for a specified length of time, however, usually five to seven
11. The sales charge for mutual years.
fund shares, quoted as a
percentage of the funds
invested; it cannot be more A fund may charge a management fee on an annual basis. The management fee is
than 8.5 percent of investment.
stated as a fixed percentage of the fund’s asset value per share. Management fees
12. A mutual fund that does not can range from 0.1 percent to 2.0 percent annually. Typically, a more actively
charge a sales commission or managed fund can be expected to charge a higher management fee, while a
fee upon investment or
passively managed fund such as an index fund should charge a minimal
purchase of shares.
management fee.
13. A deferred sales charge or sales
fee charged when shares are
redeemed. A fund may charge an annual 12b-1 fee14 or distribution fee, also calculated as not
14. An annual management fee
more than 1.0 percent per year of the fund’s asset value. Some mutual funds charge
charged to mutual fund other extra fees as well, passing on fund expenses to shareholders. You should
shareholders and calculated as consider fee structure and rate when choosing mutual funds, and this can be done
a percentage of the assets through calculations of the expense ratio.
under management.
15. The total expenses of a mutual

fund investment as a Taken together, the annual management, distribution, and expense fees are
percentage of share value. measured by the expense ratio15—the total annual fees expressed as a percentage

of your total investment. The expense ratio averages around 0.99 percent for all
mutual funds, but it may be more than 2 percent of your investment’s value.The
Investment Company Institute, 2009 Investment Company Fact Book, 49th ed., 2009,
http://www.ici.org/pdf/2009_factbook.pdf (accessed June 15, 2009). That may not
sound like much, but it means that if the fund earns a 5 percent return, your net
return may be less than 3 percent (and after taxes, it’s even less). When choosing a
fund, you should be aware of all charges—especially annual or ongoing
charges—that can affect your investment return.
Say you invest in a load fund with a 5 percent front-end load and an expense ratio
of 2.25 percent and suppose the fund earns a 5 percent return. Figure 17.3 "Mutual
Fund Example" shows how your $5,000 investment would look after one year.
Figure 17.3 Mutual Fund Example
Expenses can be a significant determinant of your net return, and since expenses
vary by fund, fund strategy (active or passive), and fund sponsor, you should shop
around and understand what your costs of investing will be.
Owning shares of a mutual fund means owning shares in a pool of assets. The
16. Mutual fund returns from any returns of the fund are the returns of those assets: interest, dividends, or gains
interest payments on the (losses). Income may come from interest distributions16 if the fund invests in
mutual fund holdings, such as
bonds or interest-producing assets or as dividend distributions17 if the fund
bonds
invests in stocks.
17. Mutual fund returns from any
dividends distributed by
mutual fund equity holdings.

Mutual funds buy and sell or “turn over” the fund assets. Even passively managed
funds need to rebalance to keep pace with their benchmarks as market values
change. The turnover ratio18 is the percentage of fund assets that have been
turned over or replaced in the past year, a measure of the fund’s trading activity.
Turnover can create capital gains or losses. Periodically, usually once per year, the
fund’s net capital gains (or losses) are distributed on a per share basis as a capital
gains distribution19. You would expect turnover to produce more gains than
losses. The more turnover, or the higher the turnover ratio, the greater the capital
gains distributions you may expect.
Unless you have invested in a tax-exempt savings plan such as an Individual

Retirement Account (IRA) or a 401(k), interest and dividend distributions are
taxable as personal income, as are capital gains, including capital gains
distributions. A higher turnover ratio may mean a higher tax expense for capital
gains distributions. Most open-end mutual funds allow you the option of having
your income and gains distributions automatically reinvested rather than paid out,
which means that you may be paying taxes on earnings without ever “seeing” the
money.
Mutual Fund Information and Strategies
All mutual fund companies must offer a prospectus20, a published statement

detailing the fund’s assets, liabilities, management personnel, and performance
record. You should always take the time to read it and to take a closer look at the
fund’s investments to make sure that the fund will be compatible and appropriate
to your investment goals.
For example, suppose you have an investment in an S&P

18. A measure of how much annual 500 Index fund and now are looking for a global stock Figure 17.4
trading activity there is within fund to complement and diversify your holdings in
a mutual fund’s holdings.
domestic (U.S.) equities. You go to the Web site of a
19. The shareholder’s share of large mutual fund company offering hundreds of funds.
capital gains (losses) created by You find a stock fund called “Global Stock
mutual fund turnover. Fund”—sounds like it’s just what you are looking for.
20. A written statement of a Looking closer, however, you can see that this fund is
mutual fund’s structure, invested in the stocks of companies in Germany, Japan,
management, investment and the United Kingdom. While they are not U.S. stocks, © 2010 Jupiterimages
objectives, holdings, and
historic and current those economies are similar to the U.S. economy, Corporation
performance; funds are perhaps too similar to provide the diversity you are
required to make the looking for.
prospectus available to all
potential investors.

Or suppose you are looking for a bond fund to create income and security. You find
a fund called the “Investment Grade Fixed Income Fund.” On closer inspection,
however, you find that the fund does not invest only in investment grade bonds but
that the average rating of its bonds is investment grade. This means that the fund
invests in many investment grade bonds but also in some speculative grade bonds
to achieve higher income. While this fund may suit your need for income, it may
not be appropriate for your risk tolerance.
Mutual fund companies make this information readily available on Web sites and in
prospectuses. You should always make the extra effort to be sure you know what’s
in your fund. In addition, mutual funds are widely followed by many performance
analysts. Ratings agencies such as Morningstar and investment publications such as
Barron’s and Forbes track, analyze, and report the performance of mutual funds.
That information is available online or in print and provides comparisons of mutual
funds that you may find helpful in choosing your fund.
In print and online newspapers, mutual fund performance is reported daily in the
form of tables that compare the average returns of funds from week to week.
Reported average returns are based on the net asset value per share (NAVPS).
Investors can use this information to choose or compare funds and track the
performance of funds they own.
In conclusion, since a mutual fund may be made up of any kind or many kinds of
securities (e.g., stocks, bonds, real estate, and commodities), it is not really another
kind of investment. Rather, it is a way to invest without specifically selecting
securities, a way of achieving a desired asset allocation without choosing individual
assets.
The advantages of investing in a mutual fund are the diversification available with
minimal transaction costs and the professional management or security selection
that you buy when you buy into the fund.
Compared to actively managed funds, passively managed or index funds offer

similar diversification but with lower management fees and expense ratios because
you aren’t paying for market timing or security selection skills. The turnover ratio
shows how passive or active the fund management is. About half of all equity
mutual funds have a turnover ratio of less than 50 percent.The Investment
Company Institute, 2009 Investment Company Fact Book, 49th ed., 2009,
http://www.ici.org/pdf/2009_factbook.pdf (accessed June 15, 2009).

Performance history has shown that actively managed funds, on average, do not
necessarily outperform passively managed funds.Burton G. Malkiel, A Random Walk
Down Wall Street (New York: W. W. Norton & Company, Inc., 2007), 360. Since they
usually have higher fees, any advantage created by active management is usually
canceled out by their higher costs. Still, there are investors who believe that some
mutual funds and mutual fund managers can, on average, outperform the markets
or the indexes that provide the benchmarks for passively managed funds.

KEY TAKEAWAYS
• Mutual funds provide investors with
◦ diversification,
◦ security selection,
◦ asset allocation.
• Funds may be actively or passively managed.
• Index funds mirror an index of securities, providing diversification
without security selection.
• Funds of funds provide the investor with preselected funds.
• Mutual funds may be structured as
◦ closed-end funds,
◦ open-end funds,
◦ exchange-traded funds.
• Some funds are structured to achieve specific investment goals:
◦ Lifestyle funds with target dates to minimize liquidity risk

through asset allocation
◦ Leveraged funds to increase return through using debt
◦ Inverse funds to increase return through active management
with the expectation of a down market
• Mutual fund costs may include
◦ a sales charge when shares are purchased, or front-end load,

◦ a sales charge when shares are sold, or back-end load,
◦ a management fee while shares are owned, or
◦ a 12b-1 (distribution) fee while shares are owned.
• The management expense ratio is the total mutual fund cost expressed
as a percentage of the funds invested.
• Fees vary by
◦ fund sponsor,
◦ fund strategy (active or passive),
◦ fund sales (direct or through a broker).

• Returns from a mutual fund include returns on the securities it

owns, including
◦ interest distributions,
◦ dividend distributions,
◦ capital gains distributions.
• A fund prospectus details the fund’s investment holdings, historic
returns, and costs. Mutual fund ratings in the financial media are
another source of information.

EXERCISES
1. View the video “Investing in Mutual Funds” at

http://efinancedirectory.com/multimedia/
Investing_in_Mutual_Funds_Video.html. According to the speaker, are
no-load funds free? Should you buy mutual funds near the end of a year?
Survey the articles and tools at “Mutual Funds 101” on Yahoo! Finance
at http://finance.yahoo.com/funds/mutual_funds_101. According to
both this source and the video, what are the two key benefits of mutual
funds? How are mutual funds classified? How can you gauge the
performance of a mutual fund? What are the costs of owning mutual
funds? Where can you get information about a mutual fund?
2. Securities regulations require complete and continuous disclosure, also
referred to as transparency, so that investors will know what they are
getting into when they invest. This requirement is partly satisfied
through a fund prospectus. Read the SEC’s advice on how to read a
prospectus and what to look for at http://www.sec.gov/answers/
mfprospectustips.htm. Then compare that information with the advice
offered at http://www.getrichslowly.org/blog/2009/04/23/how-to-
read-a-mutual-fund-prospectus/. On the same page, browse the “Best of
Get Rich Slowly” links, too. How does this information reinforce the idea
that you should thoroughly read and understand a prospectus before
investing in a fund?
3. View Morningstar’s performance data chart for various categories of
mutual funds at http://news.morningstar.com/fundReturns/
CategoryReturns.html. What general categories of funds are included in
the chart? Over what time periods are average returns compared? On
July 15, 2009, the chart identified the following funds as having average
returns of more than 5 percent after five years: natural resources stock,
utilities stock, Latin America stock, Pacific/Asia stock, diversified
emerging markets stock, emerging markets bonds, long-term
government bonds, and equity precious metals. What is the performance
of those funds today?
4. Read Investopedia’s article on the costs of investing in mutual funds at
http://www.investopedia.com/university/mutualfunds/
mutualfunds2.asp. What is your management expense ratio (MER)? Do
mutual funds with higher expenses generally earn higher returns?
5. Take Investopedia’s tutorial on how to read a mutual fund table in the
financial news at http://www.investopedia.com/university/
mutualfunds/mutualfunds4.asp. What do the columns mean? What is
being compared? What can you learn from mutual fund tables that may
help you choose funds or track the performance of funds you own?
Share your ideas with classmates.

6. In My Notes or your personal finance journal, record your study of a

fund you choose to track. Read the prospectus, check its ratings, and
compare its week-to-week performance with that of similar funds in the
mutual funds table in the financial section of a newspaper. Record your
observations, questions, and commentary as you go about deciding
hypothetically whether or not to invest in that fund.

17.2 Real Estate Investments
LEARNING OBJECTIVES
1. Distinguish between direct and indirect investments in real estate.

2. Identify the four main ways to invest in real estate indirectly.
3. Explain the role and the different kinds of REITs.
4. Discuss the role and uses of mortgage-backed securities.
When you buy a home, even with a mortgage, you are making a direct
investment21, because you are both the investor and the owner who holds legal
title to the property. For most people, a home is the single largest investment they
ever make.
As an investor, you may want to include other real estate holdings in your portfolio,
most likely as an indirect investment22 in which you invest in an entity that owns
and manages real estate. Studies have shown that real estate is a good diversifier
for financial investments such as stocks and bonds.Jack Clark Francis and Roger G.
Ibbotson, Contrasting Real Estate with Comparable Investments, 1978–2004 (Ibbotson
Associates, 2007), http://corporate.morningstar.com/ib/asp/
detail.aspx?xmlfile=1409.xml (accessed June 24, 2009).
Direct Investments
Sonia is looking to buy her first home. After graduating from college, she decided to
stay on because she liked the town and found a job as an elementary school teacher.
She loves her job, but her income is limited. She finds a nice, two-family house in a
neighborhood close to the college. It needs some work, but she figures she can use
the summer months to fix it up—she’s pretty handy—and renting to students won’t
be a problem. The tenants will pay their own utilities. Sonia figures that the rental
income will help pay her mortgage, insurance, and taxes, and that after the
mortgage is paid off, it will provide a nice extra income.
21. A real estate investment in

which you are the owner and
manager of property.
22. A real estate investment in

which you buy shares of an
entity that owns and manages
property.
522
Many real estate investors begin like Sonia, buying a

rental property that helps them to afford their own Figure 17.5
home. If you actively manage the rental property, there
are tax benefits as well. Of course, you have to provide
maintenance services and arrange for repairs, and, in
Sonia’s case, perhaps give up a bit of privacy. A second
or vacation home can be used as a rental property as
well, although the tax benefits are less assured. In both
cases, the investor is making a direct investment in the
property.
The advantages to a direct investment are the

additional rental income and tax benefits. The
disadvantages are that real estate is relatively illiquid,
and the investment concentrates your portfolio in one
asset class—residential real estate. Conventional © 2010 Jupiterimages
wisdom was that real estate was a good hedge against Corporation
inflation, but the recent burst of the housing
bubble—not only in the United States but also
worldwide—has cast a shadow on that thinking. Also, to
realize the tax benefits, you must actively manage the
rental property, and being a landlord is not for everyone.
Other direct real estate investments include

commercial property23, or property exclusively for Figure 17.6
rent, and undeveloped land. Developers buy property or
land and seek to profit from quickly improving and
reselling it. Both are more speculative investments,
especially if purchased with debt financing. They may
also prove to be illiquid and to concentrate assets,
making them inappropriate investments for investors
without a large and diversified portfolio.
Corporation
Indirect Investments
Investors who want to add a real estate investment to

their portfolio more often make an indirect investment.
That is, they buy shares in an entity or group that owns and manages property. For
example, they may become limited partners in a real estate syndicate.
23. Property used exclusively to

create rental income.
17.2 Real Estate Investments 523

A syndicate24 is a group created to buy and manage commercial property such as

an apartment, office building, or shopping mall. The syndicate may be structured as
a corporation or, more commonly, as a limited partnership.
In a limited partnership25, there is a general partner and limited partners. The

general partner manages the entity, while the limited partners invest in
partnership shares. The limited partners are only liable for the amount of their
investment; that is, they can lose only as much as they have put in. Limiting liability
is particularly important in real estate, which relies on leverage or debt financing.
Investors find syndicates valuable in limiting liability and in providing management
for the property.
Another form of indirect investing is a real estate investment trust (REIT)26—a

mutual fund of real estate holdings. You buy shares in the REIT, which may be
privately held or publicly traded on an exchange. The REIT is a fund invested in
various commercial properties. Some REITs specialize, concentrating investments
in specific kinds of property, such as shopping malls, apartments, or vacation
properties.
To qualify as a REIT in the United States (for the allowable tax benefits), a fund must
• be managed by directors as a corporation or trust,

24. A group of individuals formed • offer transferrable shares,
to own property. The syndicate • not be a financial institution,
acts as a vehicle for indirect • have at least a hundred shareholders,
investment, hiring professional
management for the properties
• have at least 95 percent of income from interest, dividends, and
it owns. property,
• pay dividends that are at least 90 percent of the REITs taxable income,
25. A partnership in which there
are both general and limited
• have at least 75 percent of its assets invested in real estate,
partners (at least one of each). • get at least 75 percent of gross revenue from real estate.
The limited partners have
limited liability, and, much like
corporate shareholders, cannot An equity REIT invests in property, while a mortgage REIT provides real estate
be liable for the partnership financing. A hybrid REIT does both. REITs do for real estate what mutual funds do
beyond their original
investment.
for other assets. They provide investors with a way to invest with more liquidity
and diversity and with comparatively lower transaction costs.
26. A corporation investing in real
estate that, practically,
behaves much like a mutual Another way to invest in the real estate market is to invest in the real estate
fund for real estate investors. financing rather than the actual real estate. Mortgage-backed securities (MBS)27
27. A security such as a bond are bonds secured by pools of mortgages owned by large financial institutions or
whose return is secured by the agencies of the federal government.
income (mortgage payments)
from a pool of mortgages.

It is difficult to price mortgage-backed securities—to gauge their present and future

value and their risk. Like any bond, mortgage-backed securities are vulnerable to
interest rate, reinvestment, and inflation risk, but they are also particularly
vulnerable to economic cycles and to default risk. If the economy is in a recession
and unemployment rises, mortgage defaults will likely rise. When mortgage
defaults rise, and the value of mortgage-backed securities falls.
Because they are complicated and risky, mortgage-backed securities are

appropriate only for investors with a large enough asset base and risk tolerance to
support the investment. MBS investors are usually institutional investors or very
wealthy individuals.
KEY TAKEAWAYS
• Direct investments in real estate involve controlling ownership and

management of the property.
• Indirect investment involves owning a share of a company that owns
and manages the real estate.
• Indirect investments may be structured as
◦ a syndicate,
◦ a limited partnership,
◦ a real estate investment trust (REIT).
• A REIT is designed as a mutual fund of real estate holdings.
◦ An equity REIT invests in property.

◦ A mortgage REIT invests in real estate financing.
◦ A hybrid REIT does both.
• Mortgage-backed securities are another way to invest in a real estate
market by investing in its financing, but they are considered too risky
for individual investors.

EXERCISES
1. View the video “Top Eight Real Estate Investment Mistakes” at

http://www.5min.com/Video/Top-Eight-Real-Estate-Investment-
Mistakes-24084962. According to the speaker, based on eight common
mistakes that real estate investors make, what eight things should you
do to succeed? The same speaker gives advice on how to be a landlord at
http://www.5min.com/Video/What-Does-It-Take-to-Be-a-
Landlord-27579055. What five points does she identify as most
important?
2. What have been your experiences as a landlord or as a tenant?
Collaborate with classmates to develop two lists: advantages and
disadvantages of direct investing in rental property and of being a
tenant in a residential or commercial space. Have you had any
experience with developing or “flipping” property for resale? What is
your opinion of direct investing in foreclosed homes to flip for profit?
For perspectives, see the 2009 Money Talks videos on this subject, such
as “Vulture Investing” at http://www.youtube.com/
watch?v=rXF1dIEvtfs&feature=fvw. According to the MSN article
“Flipping Houses Is Harder than It Looks” at http://realestate.msn.com/
article.aspx?cp-documentid=13107725, why is flipping houses so
challenging?
3. Are you already invested in real estate? Record in My Notes or your
personal finance journal information about your investment and/or
your strategy for including real estate in your investment portfolio. Will
you invest directly, indirectly, or both? What is your plan and timetable
for executing your strategy? Choose one of the REITs listed at “In
Reality” at http://www.inrealty.com/restocks/linmrt.html to track and
to consider hypothetically as an investment. What might be some
advantages and risks of investing in this or another REIT as part of your
investing strategy?

17.3 Commodities and Collectibles
LEARNING OBJECTIVES
1. Define and describe the characteristics and uses of derivative contracts.

2. Explain the roles of precious metals in an investment portfolio.
3. Describe the methods available to individual investors in making
commodities investments.
4. Compare and contrast the advantages and disadvantages of using
collectibles in an individual investment portfolio.
Some investors prefer to invest directly in the materials that are critical to an
industry or market, rather than investing in the companies that use them. For
example, if you think that the price of oil is going to rise, one way to profit from the
higher price would be to buy shares of oil companies that profit by refining oil and
selling gasoline, fuels, and other petroleum products. Another way is to buy the oil
itself as a commodity.
Commodities are raw materials—agricultural products, metals, energy sources,

currencies, and so on—that go into producing goods and services. Investing in
commodities is a way to profit directly from the raw material rather than from its
products. As discussed in Chapter 12 "Investing", commodities trading is not
new—the first commodities exchange in the United States was established in 1848.
Because they are or rely on natural resources, commodities have a largely

unpredictable supply. They have inherent risk, because they are exposed to changes
in weather or geology or global politics. Commodities trading began as a way for
commodity producers and consumers to manage their risks. These traders are
managing risks going forward; that is, they hedge by buying and selling
commodities that they expect to exist in the future. This trading is done using
future and forward contracts—types of derivatives, discussed in the Chapter 12
"Investing".
Investing in commodities involves transaction costs and a time limit on realizing

your gains (or losses), because derivatives are time-sensitive contracts created with
an expiration date.
527
Commodity investing is risky business, because it is done through

derivatives—assets whose value depends on the value of another asset. For instance,
the value of a contract to buy or sell soybeans at some time in the future depends
on the value of the soybeans. When you invest in a derivative, you are taking on the
risk of both contract and the asset that it depends on. One strategy to manage this
risk is to invest in both, creating a situation in which one investment can act as a
hedge for the other. The way this works is if the underlying asset (the soybeans)
gains value, you’ll lose on the derivative (the futures contract on soybeans); but if
the asset loses value, you can gain on the derivative.
One example of this is the “prebuy” offer common in

regions where homes are heated by oil. When you heat Figure 17.7
your home with oil, you are exposed to the risk of
volatility in the price of oil. This volatility can upset
your household budget and, since heat is a necessity,
can take away from your other spending needs. You
could guarantee your winter’s cost of oil by buying it all
in the summer, but you would need a huge oil tank to
store all that oil until winter. As an alternative and to
attract customers, some heating oil suppliers offer a
prebuy deal. During the summer, customers can buy
their winter’s supply of oil at a set price, and the oil
company will then deliver it as needed over the winter
months.
If the price of oil goes up, the customer is protected and

gains by not having to pay the higher price. The oil Corporation
dealer loses the extra profit it could have had. On the
other hand, if the price of oil goes down, the dealer is
assured its profit, while the customer pays more than
necessary without the prebuy deal.
In the language of commodities trading, the customer is “short” oil, that is, needs it
and seeks to lock in a price through the prebuy deal. The oil dealer is “long” oil,
that is, has a supply and wants to sell it and so seeks to lock in the sale of a certain
quantity at a certain price. The customer wants to lock in a low price, while the
dealer wants to lock in a high price. Each is betting on what will be “low” and
“high” relative to what the real price of oil turns out to be in the future. The hedge
of the prebuy deal relieves both the customer and the dealer of the uncertainty or
risk. The deal creates its own risks, but if those are smaller than the risk of oil’s
price volatility, then the dealer will offer the prebuy, and the customer will take it.
17.3 Commodities and Collectibles 528

When you trade commodities, you are also exposed to the risks of trading in the
commodities markets. Another reason that commodities investing is risky for
individual investors is because professional commodity investors often take
speculative positions, betting on the future price of derivatives without holding
investments in the underlying assets. Speculators can influence that future price,
which after all is just the market’s consensus of what that price “should” be. For
individual investors, the risks of commodities trading often outweigh the advantage
of whatever diversification they bring to the portfolio.
Gold, Silver, and Precious Metals
Historically, gold and silver have been popular investments of individual investors.
For thousands of years, gold and silver have been used as a basis for currency value,
either minted into coins or used to back currency value. When a currency is backed
by gold, for example, or is “on the gold standard,” there should be a direct
relationship between the value of the currency and the value of the gold.
In times of inflation or deflation, investors worry that the value or purchasing

power of currency will change. They may invest in gold or silver as a more stable
store of wealth than the currency that is supposed to represent the metal. In other
words, if investors lose faith in the currency that represents the gold, they may
trade their money for the gold.
Most currencies used today are not backed by a precious metal but by the
productivity and soundness of the economy that issues them. For example, the
value of the U.S. dollar is not related to the value of an ounce of gold, but to the
value of the U.S. economy.
When economic or political turmoil seems to threaten the health of an economy

and hence the value of its currency, some investors choose to invest in the gold or
silver that seems to retain its value. For that reason, gold or silver has historically
been regarded as a hedge against inflation.

How exactly do you buy gold? Gold bullion is sold as

bars or wafers in units of one kilogram or 32.15 troy Figure 17.8
ounces. Metal dealers and some banks will sell bars or
wafers ranging from 5 grams (or 0.16075 troy ounces) to
500 ounces or more. Transaction costs are relatively
high, between 5 percent and 8 percent, and there is the
cost of storing and securing the gold bars or wafers.
A more popular way to buy gold is as coins, which are

more easily stored and secured. Gold coins are minted
by several countries, including the United States, and Corporation
may be bought from banks, brokers, and dealers for a
fee of about 2 percent.
Commodity Indexes and Exchange-Traded

Funds
As with stocks, bonds, and real estate, the most popular way for individual investors
to invest in any commodities—including precious metals—is through open-end
mutual funds or exchange-traded funds (ETF). The fund may invest in a variety of
contracts, diversifying its holdings of the commodity. It has professional managers
who understand the pricing of such contracts and can research the market
volatility and the global economy. Using a fund as a way of investing in
commodities thus provides both diversification and expertise. It can also give you
more liquidity as fund shares can be quickly traded into the market.
For example, if you expect inflation and want to buy gold, instead of trying to buy
gold bars, you could invest in a fund (iShares), an exchange-traded fund (Comex
Gold), or mutual funds (Fidelity Select Gold or Vanguard Precious Metals). These
funds allow you to “own” gold but also to get diversification, expertise, and
liquidity, reducing your risk.
There are mutual funds or exchange-traded funds for nearly every commodity that
is traded. There are also passively managed commodity index funds, similar to stock
or bond index funds. Investing in commodities can be a way to achieve asset
diversification in your portfolio, because often a commodity such as gold is
countercyclical to the economy, and therefore is countercyclical to your stock and
bond holdings as well. Commodities may also add significant risk to a portfolio,
however, so the advantage of adding them as a diversification strategy may be
canceled out by the additional risk.

Collectibles and Unique Investments
Any asset that is tradable may become an investment; that is, it may be purchased
and held with the expectation that it can be sold when its value increases. So long
as there is a market for it—a buyer—it potentially may be sold at a gain.
Collectibles and unique investments include the following:
• Antique furniture
• Stamps
• Coins
• Rare books
• Sports trading cards
• Vintage cars
• Vintage clothes
• Vintage wines
• Vintage vinyl
• Fine art
• Musical instruments
• Jewelry
• Historical curios
• Other ephemera
As investments, collectibles cannot be standardized in the way that stocks, bonds,

or even real estate and used cars can be. Each asset has attributes that make it more
or less valuable, even among similar assets. Its value is hard to judge, and therefore
it is harder for buyer and seller to agree on a price.
Professional appraisers are knowledgeable about both the item and the market and
are trained to evaluate such assets. Theirs is a better-educated guess, but it is still
just an estimate of value. Individual investors also consult books on collectibles and
may purchase professional market research, pricing indexes, and auction records.
Sometimes one person’s trash is another person’s treasure. It is fun to think that
you may unearth a rare “find” at a garage sale or flea market or that some family
heirloom has more than sentimental value. Usually, however, your ability to cash in
on your luck is limited by your ability to convince someone else of its worth and to
sell when its market is trendy.
Collectibles, including “ephemera” such as antique letters and photographs, are

usually sold by dealers or collectors or through a private sale arranged between

buyer and seller. The dealers may establish a gallery to showcase items for sale.
Auction houses such as Christie’s or Sotheby’s organize auctions of many items or
“lots” to attract buyers and provide catalogues with details on the items for sale,
such as their “provenance” or ownership history.
The advantage of unique assets as investments is that you may enjoy collecting and
having the items as well as watching their value appreciate. If you are a guitarist,
for example, having and being able to play a vintage guitar may mean more to you
than the fact that it may be a good investment. For some, collecting becomes a
hobby.
The disadvantages of investing in collectibles are
• high probability of mispricing, as markets are inefficient;

• lack of liquidity;
• lack of earnings, as there are no dividends or interest;
• holding costs of the investment.
Unless you are knowledgeable about your item and its markets (and even if you
are), it is common to suffer from mispricing. Collectibles’ markets are relatively
inefficient because trading partners vary widely in their knowledge about pricing.
Both buyers and sellers try to persuade each other of an asset’s rarity and value. It
is easy to be misled and to make mistakes in this market. Online sales and auctions
of collectibles at sites such as eBay may be fun for hobbyists, but they typically are
not good venues for investors.
If you are trading through a dealer, you can check the dealer’s reputation through
professional organizations, local business bureaus, and Internet blogs and Web
sites, especially where customers can provide a rating or critique. You should also
always try to find comparable items to compare prices. If feasible, get a second
opinion from an independent appraiser. Knowledge is an important bargaining
chip. The more you know, the more likely you are to be satisfied with your
investment decision, even if you ultimately walk away from the deal.

Unique investments may not be readily saleable, or

their markets may be subject to trends and fashions that Figure 17.9
cause price volatility. This means that your investment
may ultimately be a source of gain but that you cannot
count on it as a source of liquidity. If you have
foreseeable liquidity needs, it may not be appropriate to
tie up your wealth in a Chinese vase, autographed
baseballs, vintage action figures, or Navajo rugs.
There are no dividends or interest paid while you hold

collectibles, so if you have income needs you should © 2010 Jupiterimages
choose a more useful investment. There are also other Corporation
costs, such as storage, security, maintenance, and
insurance. Your investment actually returns a negative
net cash flow—costs you more than it brings in—until
you realize its potential gain by selling it.
Collectibles can be a source of joy and a store of wealth, and you may realize a
healthy return on your investment. In the meantime, however, they create costs so
that your eventual return will have to be large enough to compensate for those
costs to make them a really worthwhile investment.

KEY TAKEAWAYS
• Commodities are raw materials and agricultural products.

• Commodities are used to produce other goods and so are traded forward
using derivative contracts.
• Derivative contracts can be used to hedge an investment in an asset, or
to speculate on the price volatility of the commodity.
• Because of their volatility, commodities markets are riskier than asset
markets.
• Precious metals, especially gold, are often used to lower portfolio risk by
providing a hedge against inflation.
• Individual investors can invest in commodities using index funds and
exchange-traded funds.
• Collectibles and unique assets may appreciate in value, acting as

a store of wealth, but the disadvantages of using them as
investments are
◦ high probability of mispricing,

◦ illiquid markets,
◦ illiquid returns or no returns until the asset is sold,
◦ holding period maintenance costs.

EXERCISES
1. View Bloomberg’s commodities and futures charts at

http://www.bloomberg.com/markets/commodities/cfutures.html.
Choose one or two commodities to track and find out all you can about
investing in those commodities. Read an article on how to read a
commodities price chart at http://www.thegraintrader.com/chart-
patterns/how-to-read-a-commodity-price-chart.html. Create an
annotated drawing to apply the information about reading a
commodities chart to an example of a chart taken from the Bloomberg’s
Web site. Write an interpretation of the chart in My Notes or your
personal finance journal.
2. Read Investopedia’s article on investing in gold and silver at
http://www.investopedia.com/articles/optioninvestor/06/
goldsilverfutures.asp. According to this source, who should consider
investing in gold and silver and for what reason? What are examples of
other precious metals in the futures market? How do investors offset
futures contracts before their delivery dates?
3. Sample the collectibles listed on eBay at http://popular.ebay.com/ns/
Collectibles.html. Are there any that interest you that you would
consider investment grade? Why or why not? What has been your
experience with buying and selling collectibles? In what circumstances
might you consider adding investments in a collectible to your
portfolio? What would you collect? Research this collectible to
determine current pricings, locate markets, and identify dealers and
experts. What would you have to sacrifice to invest in this collectible?
How much could you make in the future?

Chapter 18
Career Planning
Introduction
Bryon always knew he wanted to be a fireman. He can remember as a kid being

elated by the fire trucks as they screamed past on their way to helping people. He
has always been sure that a career in protection services is the right choice for him.
Given that people will always need those services, Bryon figures he’ll have job
security, will be able to raise a family, and will have many chances for advancement
along with plenty of thrills on the job.
Although she is starting out as a lab technician, Tomika is not clear about her career
ambitions. She wants to do something fun and interesting, where she won’t hate
going to work every day—but mostly she wants a career that will afford her the
opportunity for professional advancement, increasing pay, and the chance to raise a
family. She has enjoyed her science courses at school. She figures that since health
care is a growth industry, with technological advancements and the aging
population, she will choose a career in health.
Some people know what they want to do at an early age.

For most people, however, the path is just not that clear. Figure 18.1
Career planning and development can be a process of
trial and error as you learn your abilities and
preferences by trying them out. Sometimes a job is not
what you thought it would be, sometimes you are not
who you thought you would be. The better your
decision-making process—the more objective and
methodical it is—the less trial and error you will have to
endure.
Your financial sustainability depends on having income

to support your spending, saving, and investing. A © 2010 Jupiterimages
primary component of your income—especially earlier Corporation
in your adult life—is income from your wages or salary,
that is, from working, selling your labor. Your ability to
maximize the price that your labor can bring depends
on the labor market you choose and your ability to sell
536
Chapter 18 Career Planning
yourself. Those abilities will be called on throughout your working life. You will
make job and career choices for many different reasons. This chapter looks only at
the financial context of those choices.
537
18.1 Choosing a Job
LEARNING OBJECTIVES
1. Describe the macroeconomic factors that affect job markets.

2. Describe the microeconomic factors that influence job and career
decisions.
3. Relate life stages to both microeconomic factors and income needs.
4. Describe how relationships between life stages, income needs, and
microeconomic factors may affect job and career choices.
A person starting out in the world of work today can expect to change careers—not
just jobs—an average of seven times before retiring.U.S. Department of Labor,
Bureau of Labor Statistics, “National Longitudinal Survey of Youth,”
http://www.bls.gov/nls/nlsy79r19sup1.pdf (accessed July 23, 2009). Those career
changes may reflect the process of gaining knowledge and skills as you work or
changes in industry and economic conditions over several decades of your working
life. Knowing this, you cannot base career decisions solely on the circumstances of
the moment. However, you also cannot ignore the economics of the job market.
You may have a career in mind but have no idea how to get started, or you may
have a job in mind but have no idea where it may lead. If you have a career in mind,
you should research its career path1, or sequence of steps that will enable you to
advance. Some careers have a well-established career path—for example, careers in
law, medicine, teaching, or civil engineering. In other occupations and professions,
career paths may not be well defined.
Before you can even focus on a career or a job, however, you need to identify the
factors that will affect your decision making process.
Macro Factors of the Job Market
The job market is the market where buyers (employers) and sellers (employees) of
labor trade, but it usually refers to the possibilities for employment and its rewards.
These will differ by field of employment, types of jobs, and geographic region. The
opportunities offered in a job market depend on the supply and demand for jobs,
which in turn depend on the need for labor in the broader economy and in a
1. A planned progression of jobs
or steps to advance in a specific industry or geographic area.
profession or career.
538
The economic cycle can affect the aggregate job market or employment rate. If the
economy is in a recession, the economy is producing less, and there is less need for
labor, so fewer jobs are available. If the economy is expanding, production and its
need for labor are growing.
Typically, a recession or expansion affects different industries in different ways.

Some industries are cyclical and some are countercyclical. For example, in a
recession, consumer spending is often down, so retail shops and consumer goods
manufacturers—in cyclical industries—may be cutting jobs. Meanwhile, more
people are continuing their education to improve their skills and the chances of
getting a job, which is harder to do in a recession, so jobs in higher education—a
countercyclical industry—may be increasing.
For example, it would have been a bad time in the spring of 2009 to think about a
career in auto manufacturing in the United States with Ford, General Motors, and
Chrysler all announcing massive layoffs, plant closings, and facing bankruptcy. The
industry may survive, but it probably won’t be able to rebuild that fast.
Global events such as an outbreak of war, the nationalization of a scarce natural

resource, the price of a critical commodity such as crude oil, the collapse of a vital
industry, and so on, may also cause changes in the global economy that affect job
markets.
Another macroeconomic factor is change in technology, which can open up new

fields of employment and make others obsolete. With the advent of digital cameras,
for example, even single-use conventional cameras are no longer being
manufactured in great quantity, and film developers are not needed as much as
they once were. However, there are more jobs for developers of electronic cameras
and digital applications for creating images and using digital images in
communications channels, such as mobile phones.
18.1 Choosing a Job 539

A demographic shift also can change entire industries

and job opportunities. A historical example, repeated in Figure 18.2 Workers in the
many developing countries, is the mass migration of Vacuum Cleaner Factory at
rural families to urban centers and factory towns during Reedsville, West Virginia
an industrial revolution. Changes in the composition of
a society, such as the average age of the population, also
affect job supply and demand. Baby booms create
demand for more educators and pediatricians, for
example, while aging populations create more demand
for goods and services relating to elder care.
Social and cultural factors affect consumer behavior, Library of Congress, February
and consumer preferences can change a job market. 1937
Demand for certain kinds of products and services, for
example, such as organic foods, hybrid cars, clean
energy, and “green” buildings, can increase job
opportunities in businesses that address those preferences.
Thus, changes in demand for a product or service will change the need for labor to
produce it. On a larger scale, economies typically shift their focus over time as
different industries become “growth” industries, that is, the drivers of growth in
the economy. In the mid-twentieth century, the United States was a manufacturing
economy, driven by the production of durable and consumer goods, especially
automobiles. In the 1990s, the computer/internet/tech sector had a larger role in
driving growth in the U.S. economy due to technological breakthroughs. Currently,
education and health care services are the growing sectors of the economy due to
demographic and political changes and needs.U.S. Department of Labor, Bureau of
Labor Statistics, “Industries with the Fastest Growing and Most Rapidly Declining
Wage and Salary Employment, 2006–16,” in “Industry Output and Employment
Projections to 2016,” Monthly Labor Review, November 2007, http://www.bls.gov/
emp/empfastestind.htm (accessed August 5, 2009).
If you are entrepreneurial and intend to be self-employed, your job opportunities

may be affected by the ease with which you can start and maintain a business. Ease
of entry, in turn, may be affected by macro factors such as the laws and regulations
in the state where you intend to do business and the existing competition in the
market you are entering.
The labor market is competitive, not just at an individual level but on a global,
industrywide scale. As transportation and especially communication technology has
improved, many steps in a manufacturing or even a service process may be
outsourced, done by foreign labor. That competition affects the U.S. job market as

jobs are moved overseas, but it also opens new markets in developing economies.
You may be interested in an overseas job, as American companies open offices in
Asian, South American, African, and other countries. Globalization affects job
markets everywhere.
Micro Factors of Your Job Market
Whether you are employed or self-employed, whether you look forward to going to
work every day or dread it, employment determines how you spend most of your
waking hours during most of your days. Employment determines your income and
thus your lifestyle, your physical well-being, and to a large extent your satisfaction
or emotional well-being. Everyone has a different idea about what a “good job” is.
That idea may change over a lifetime as circumstances change, but some specific
micro factors will weigh on your decisions, including your
• abilities,
• skills,
• knowledge,
• lifestyle choices.
Abilities are innate talents or aptitudes, what you are capable of or good at.
Circumstances may inhibit your use of your abilities or may even cause disabilities.
However, you often can develop your abilities—and compensate for
disabilities—through training or practice. Sometimes you don’t even know what
abilities you have until some experience brings them out.
When Tomika says she is “good with people” or when Bryon says that he is a
“natural athlete,” they are referring to abilities that will make them better at some
jobs than others. Abilities can be developed and may require upkeep; athletic
ability, for example, requires regular fitness workouts to really be maintained. You
also may find that you lack some abilities, or think you do because you’ve never
tried using them.
Usually, by the time you graduate from high school, you are aware of some of your
abilities, although you may not be aware of how they may help or hinder you in
different jobs. Also, your idea of your abilities relative to others may be skewed by
your context. For example, you may be the best writer in your high school, but not
compared to a larger pool of more competitive students. Your high school or
college career office may be able to help you identify your abilities and skills and
applying that knowledge to your career decisions.

Your job choices are not predetermined by your abilities or apparent lack of them.
An ability can be developed or used in a way you have not yet imagined. A lack of
ability can sometimes be overcome by using other talents to compensate. Thus,
ability is a factor in your job decisions, but certainly not the only one. Your
knowledge and skills are equally—if not more—important.
Skills and knowledge are learned attributes. A skill is a process that you learn to
apply, such as programming a computer, welding a pipe, or making a customer feel
comfortable making a purchase. Knowledge refers to your education and
experience and your understanding of the contexts in which your skills may be
applied.
Education is one way to develop skills and knowledge. In secondary education, a

vocational program prepares you to enter the job market directly after high school
and focuses on technical skills such as baking, bookkeeping, automotive repair, or
building trades. A college preparatory program focuses on developing general skills
that you will need to further your formal education, such as reading, writing,
research, and quantitative reasoning.
Past high school or a year or two of community college, it is natural to question the
value of more education. Tuition is real money and must be earned or borrowed,
both of which have costs. There is also the opportunity cost of the wages you could
be earning instead.
Education adds to your earning power significantly, however, by raising the price of
your labor. The more education you have, the more knowledge and skills you have.
The smaller the supply of labor with your particular knowledge and skills, the
higher the price your labor can command. This relationship is the rationale for
becoming specialized within a career. However, both specialization and versatility
may have value in certain job markets, raising the price of your labor.
More education also confers more job mobility—the ability to change jobs when
opportunities arise, because your knowledge and skills make you more useful, and
thus valuable, in more ways. Your value as a worker or employee enables you to
command higher pay for your labor.
Statistics show a consistent relationship between education and earnings. Over a

lifetime of work, say about forty to forty-five years, in the United States a person
with a college degree will earn over a million dollars more than someone with a
high school diploma. According to a recent study,

“There is a positive correlation between higher levels of education and higher

earnings for all racial/ethnic groups and for both men and women…The income gap
between high school graduates and college graduates has increased significantly
over time. The earnings benefit is large enough for the average college graduate to
recoup both earnings forgone during the college years and the cost of full tuition
and fees in a relatively short period of time.”Sandy Baum and Jennifer Ma, Education
Pays: The Benefits of Higher Education for Individuals and Society (Princeton, NJ: The
College Board, 2007).
Not only are you likely to earn more if you are better educated, but you are also
more likely to have a job with a pension plan, health insurance, and paid
vacations—benefits that add to your total compensation. Although it may seem
quite expensive to you now, your college education is definitely worth it: worth the
opportunity cost and worth the direct costs of tuition, fees, and books.Sandy Baum
and Jennifer Ma, Education Pays: The Benefits of Higher Education for Individuals and
Society (Princeton, NJ: The College Board, 2007).
Your choices will depend on the characteristics and demands of a job and how they
fit your unique constellation of knowledge, skills, personality, characteristics, and
aptitudes. For example, your knowledge of finance, visual pursuit skills, ability to
manage stress and tolerate risk, aptitude for numerical reasoning, enjoyment of
competition, and preference to work independently may suit you for employment
as a stockbroker or futures trader. Your manual speed and accuracy, verbal
comprehension skills, enjoyment of detail work, strong sense of responsibility,
desire to work regular hours in a small group setting, and preference for public
service may suit you for training as a court stenographer. Your word fluency, social
skills, communication skills, organizational skills, preference to work with people,
and desire to lead others may suit you for jobs in education or sales. And so on.
Lifestyle choices affect the amount of income you will

need to achieve and maintain your lifestyle and the Figure 18.3
amount of time you will spend earning income. Lifestyle
choices thus affect your career path and job choices in
key ways. Typically, when you are beginning a career
and have few, if any, dependents, you are more willing
to sacrifice time and even pay for a job that will enhance
your skills and help you to progress along your career
path. As a journalist, for example, you may volunteer for
an overseas post; or as a nurse you may volunteer for © 2010 Jupiterimages
extra rotations. As a computer programmer, you may Corporation
assist in the development of open source software.

As you advance in your career, and perhaps become more settled in your
life—maybe start a family—you are less willing to sacrifice your personal life to your
career, and may seek out a job that allows you to earn the income that supports
your dependents while not taking away too much of your time.
Your income needs typically increase as you have dependents and are trying to save
and accumulate wealth, and then decrease when your dependents are on their own
and you have accumulated some wealth. Your sources of income shift as well, from
relying on income from labor earlier in your life to relying on income from
investments later.
When your family has grown and you once again have fewer dependents, you may
really enjoy fulfilling your ambitions, as you have decades of skills and knowledge
to apply and the time to apply them. Increasingly, as more people retain their
health into older age, they are working in retirement—earning a wage to improve
their quality of life or eliminate debt, turning a hobby into a business, or trying
something they have always wanted to do. Your life cycle of career development
may follow the pattern shown in Figure 18.4 "Lifecycle Career Development".
Figure 18.4 Lifecycle Career Development
Regardless of age, your lifestyle choices will affect your job opportunities and
career choices. For example, you may choose to live in a specific geographic region
based on its
• rural or urban location,

• proximity to your family or friends,

• differences or similarities to where you grew up,
• cultural or recreational offerings,
• political characteristics,
• climate,
• cost of living.
Sometimes you may choose to sacrifice your lifestyle preferences for your
ambitions, and sometimes you may sacrifice your ambitions for your preferences.
It’s really a matter of figuring out what matters at the time, while keeping in mind
the effect of this decision on the next one.
KEY TAKEAWAYS
• Macroeconomic factors affect job markets, including
◦ economic cycles,
◦ new technology or obsolescence,
◦ demographic changes,
◦ changes in the global economy,
◦ changes in consumer preferences,
◦ changes in laws and regulations.
• Job markets are globally competitive.
• Microeconomic factors influence job and career decisions,

including
◦ abilities or aptitudes,
◦ skills and knowledge,
◦ lifestyle choices.
• Microeconomic factors and income needs change over a lifetime and
typically correlate with age and stage of life.
• Job and career choices should realistically reflect income needs.

EXERCISES
1. Record in My Notes or your personal finance journal your work history

and current thoughts about your future work life. What jobs have you
held? In each job, what experience, knowledge, or skills did you acquire
or develop? What are your future job preferences, and why do you
prefer them? Do you have a planned career path? What potential
advantages and opportunities do your preferences or plans offer? What
potential disadvantages and costs may your preferences or plans entail?
2. Go online to find out the differences in definition between an occupation
and a vocation, profession, trade, career, and career path. Which
combination of concepts best describes the approach you plan to take to
satisfy your needs for income from future employment? Sample the
links at http://www.rileyguide.com/careers.html. Choose and record or
bookmark the three best online sources of career information for you.
3. Take a free online career development aptitude test, such as the one at
http://www.careertest.us/Career_Aptitude_Survey.htm. (Note that sites
offering free aptitude, personality, or job preference tests often require
online registration. You should evaluate the reliability, credibility, and
security of any site you use to explore your career preferences.) What
personality attributes and personal aptitudes are micro factors that may
affect your career choices or your chances of success in a particular job?
View the kinds of assessments you may be asked to take as a job
applicant or employee at http://www.ppicentral.com/Pdf/
Employee_Aptitude_Survey.pdf. What aptitudes are included in the
battery of tests that make up the Employee Aptitude Survey? How might
an employer use the test results?
4. In My Notes or your personal finance journal, list your most important
job skills, aptitudes, and preferences on which you plan to expand or
build a career. Then list the specific job skills you feel you need to
develop further through additional education or experience. How and
where will you get those skills and at what cost? Next, describe the
lifestyle you hope to support through income from future employment.
What aspects of that lifestyle would be easiest for you to modify or
sacrifice for your career or income goals?

18.2 Finding a Job
LEARNING OBJECTIVES
1. List and describe venues for finding job opportunities.

2. Explain the value of networking.
3. Trace the steps in pursuing a job opportunity, specifically your cover
letter, résumé, and interview.
4. Identify the critical kinds of information that should be provided in a
job offer.
A job search is a part of everyone’s life, sooner or later. It may be repeated

numerous times throughout your career. You may initiate a job search in hopes of
improving your position and career or changing careers, or you may be forced into
the job market after losing your job. Whatever the circumstances, when you look
for a job you are seeking a buyer for your labor. The process of having to “sell”
yourself (your time, energy, knowledge, and skills) is always revealing and valuable.
Finding a Job Market
Before you can look for a job, you need to have an idea of what job market you are
in. The same macro factors that you consider in your choice of career may make
your job search easier or harder. Ultimately, they may influence your methods of
searching or even your job choice itself. For example, as unemployment has
increased in the wake of the most recent financial crisis, the labor market has
become much more competitive. In turn, job seekers have become much more
creative about advertising their skills—from broader networking to papering a
neighborhood with brochures on windshields—and more accepting of job
conditions, including lower compensation. A good place to start is the U.S.
Department of Labor’s “Occupational Outlook Handbook.”See, for example, U.S.
Department of Labor, Bureau of Labor Statistics, http://www.bls.gov/oco, and
“Tomorrow’s Jobs,” http://www.bls.gov/oco/print/oco2003.htm (accessed July 20,
2009). The handbook is updated annually. For hundreds of industries and specific
jobs it tells you the training and education you need, what you will earn and what
your job prospects are, what the work entails, and what the working conditions are
like. The site also offers valuable tips on conducting job searches.
Knowing the job classification and industry name will focus your search process and
make it more efficient. Once you understand your job market, look at the macro and
547
micro factors that affect it along with your personal choices. For example, knowing
that you are interested in working in business, transportation, or the leisure and
hospitality industry, you are ready to research that field more and plan your job
search.
You are looking for a buyer of your labor, so you need to find the markets where
buyers shop. One of the first things to do is find out where jobs in your field are
advertised. Jobs may be advertised in
• trade magazines,
• professional organizations or their journals,
• career fairs,
• employment agencies,
• employment Web sites,
• government Web sites,
• company Web sites,
• your school’s career development office.
Figure 18.5 "Sources of Information about Jobs" describes these venues in more
detail.
18.2 Finding a Job 548

Figure 18.5 Sources of Information about Jobs
Consider Sandy, for example, who is graduating with a bachelor’s degree in

hospitality management. Her dream job is to work at an inn or bed and breakfast in
a resort location. The Professional Association of Innkeepers International (PAII)
offers a Web site and journal—good places to start reading and learning about the
industry. It also lists upcoming trade conferences that may be a good opportunity
for Sandy to meet some people in the industry.The Professional Association of
Innkeepers International, http://www.paii.org (accessed July 23, 2009).
Browsing online, Sandy learns about a big job fair

coming to her region, sponsored by the PAII in Figure 18.6
association with a chamber of commerce and an
economic development agency. This is her chance to
meet recruiters in her industry and find out about
actual opportunities. Each prospective employer will
have a table, and Sandy will go from table to table,
getting information, dropping off her résumé, and
possibly setting up interviews.

She also plans to register with an employment agency

that specializes in hotel management for smaller hotels © 2010 Jupiterimages
and inns. The agency will screen her application and try Corporation
to match her with appropriate jobs in its listings. For a
specified time it will keep her résumé on file for future
opportunities.
Sandy’s strategy includes posting her résumé on employment web sites, such as
Monster.com, and Careerbuilder.com. Browsing jobs online, Sandy discovers there
is a strong seasonal demand for hospitality workers on cruise ships, and this gives
her an idea. If the right choice doesn’t come up right away, maybe a summer job
working for a cruise line would be a good way to develop her knowledge and skills
further while looking for her dream job in management.
Sandy needs to research destinations as well as businesses and wants to talk with
people directly. She knows that cold calls—calling potential employers on the
phone as a complete unknown—is the hardest way to sell herself. In any industry,
cold calling has a much lower success rate than calling with a referral or some
connection—otherwise known as networking.
Networking2 is one of the most successful ways of finding a job. It can take many
forms, but the idea is to use whatever professional, academic, or social connections
you have to enlist as many volunteers as possible to help in your job search.
According to popular theory, your social networks can be seen as assets that
potentially help you build wealth. That is, the number and positions of people you
can network with and the economically viable connections you can have with them
are a form of capital—social capital3.Robert Putnam, Bowling Alone: The Collapse and
Revival of American Community (New York: Simon & Schuster, 2000).
Word of mouth is a powerful tool, and the more people know about your job search,
the more likely it is that they or someone they know will learn of opportunities.
Sandy’s strategy also includes joining online career networking sites, such as
LinkedIn, and discussion lists for people in the hospitality industry. Sandy finds a
helpful Yahoo! group called The Innkeeper Club and posts a query about what
employers look for in a manager.
2. A process of using personal

contacts to get information
and find job opportunities.
3. Connections within and

between social networks that
may be useful, as an asset, in a
market.

While Sandy was in college getting her degree in

hospitality management, her best friend from high Figure 18.7
school was happily styling hair in a local salon. Sandy
never thought to network through her friend, but it
turns out that one of her friend’s clients has a sister who
owns a country inn with her husband, and they are
thinking about hiring someone to manage their
enterprise. After driving several hours to meet them,
Sandy learns they have changed their minds and are not
hiring now. However, they know of two other © 2010 Jupiterimages
innkeepers who may be looking for help. Since they are Corporation
impressed with Sandy, they are happy to pass along her
name and résumé.
That’s how networking works—you just never know who may be helpful to you. The
obvious people to start with are all the people that you know: former professors,
former employers, friends, family, friends of family, friends of friends, family of
friends, and so on. The more people you can talk with or send your résumé to (i.e.,
impress), the greater the chances that someone will make an offer.
Another good networking strategy is to call or e-mail people working in the

industry, individuals who are currently in or just above the position you’d like to
have, and ask to talk with them about their work. If you make it clear that you are
not asking for or expecting a job offer from them, many people will be happy to
take a half hour to discuss their jobs with you. They may have valuable tips or leads
for you or be willing to pass along your name to someone else who does.
Selling Yourself: Your Cover Letter and Résumé
To get a job you will have to convince someone who does not know you that you are
worth paying for. You have an opportunity to prove that in your cover letter and
résumé and again in your interview.
The cover letter, whether mailed or an e-mailed, is your introduction to your

prospective employer. You have three paragraphs on one page to briefly introduce
yourself and show how you can make a profitable contribution to the company. The
objective of the cover letter is to get the reader to look at your résumé with a
favorable impression of you created by the letter.
Your first paragraph should establish your purpose in making contact, the reason
for the letter. You should make it clear what job you are applying for and why you
are making this particular contact. If someone referred you, mention him or her by

name. If you met the addressee previously, remind him or her where and when that
was, for example, “It was great to chat with you at the Jobs Fair in Cleveland last
week.” The more specifically you can identify yourself and separate yourself from
the pool of other job seekers, the better.
The second paragraph of your cover letter should summarize your background,
education, and experience. All this information is on your résumé in more detail, so
this is not the place to expound at length. You want to show briefly that you are
qualified for the position and have the potential to make a contribution.
Your third paragraph is your opportunity to leave the door open for further
communication. Make it clear where and how you can be reached and how much
you appreciate the opportunity to be considered for the position.
The résumé4, the summary list of your skills and knowledge, is what will really sell
you to an employer, once you have made a good enough impression with the cover
letter to get him or her to turn the page. A good résumé provides enough
information to show that you are willing and able to contribute to your employer’s
success—that it is worth it to hire you or at least to talk to you in an interview.
List the pertinent facts of where and how you can be reached: address, phone
number, e-mail address. Your qualifications will be mainly education and
experience. List any degrees, certificates, or training you have completed after high
school. Be sure to include anything that distinguishes your academic career, such as
honors, prizes, or scholarships.
List any employment experience, including summer jobs, even if they don’t seem
pertinent to the position you are applying for. You may think that being a camp
counselor has nothing to do with being a radiology technician, but it shows that you
have experience working with children and parents, have held a position where you
are responsible for others, and that you are willing to work during your school
breaks, thus showing ambition. If you are starting out and can’t be expected to have
lots of employment experience, employers looks for hints about your
character—things like ambition, initiative, responsibility—that may indicate your
success working for them.
Internships that you did in college or high school are also impressive, showing your
4. A document that summarizes
willingness to go beyond the standard curriculum and learn by working—something
job experience, education, and an employer will expect you to continue to do on the job, too. While you are in
civic activities. It is commonly school, you should recognize the value added by experiential learning and the
used in the job application positive impression that it will make. An internship can also give you a head start in
process.

networking if your supervisor will be a good reference or source of contacts for you.
The internship may even result in a job offer; you may not necessarily want to
accept, but at the very least, having an offer to fall back on takes some of the
pressure off your search.
For each job, be clear about the position you held and the two most important
duties or roles you performed. Don’t go into too much detail, however. The time to
expand on your story is in the interview.
If you have done internships or volunteer work or if you are a member of civic or
volunteer organizations, be sure to list those as well. They are hints about you as a
person and may help you to stand out in the pool of applicants.
A common mistake is to list too much extra information on your résumé and to
focus too much on what you want. For example, stating an objective such as “to
obtain a great position in hotel management.” Your employer cares about what you
can do for the company, not for yourself. The following are some tips for developing
your résumé:
• Avoid adjectives or adverbs when describing your past performance. If

you were an achiever in school, that will be reflected in your grades,
degrees, honors, and awards. “Hype” can sound boastful; besides, you
can discuss your performance in detail at the interview.
• Be honest and state your case without exaggeration. It is easier than
ever for employers to check on your history, and they will. Falsification
of information on your résumé may become grounds for dismissal, if
you are hired.
• Don’t include personal details unless they are strongly relevant to the
job you are seeking. Employers typically do not want to know that you
love dogs, were raised in Singapore, or are a single mother.
• Be correct. Proofread your résumé and have someone else proof it as
well. This is your opportunity to make a good impression. Any error
indicates not just that you made an error, but that you are sloppy, lazy,
or willing to let your work go public with errors.
• Keep it to one page, if possible. Employers typically are looking at
many résumés to fill one position, so make it easy and quick for the
reader to see how qualified you are.
A myriad of sample résumés and sample cover letters may be found online, but be
wary of templates that may not fit you or your prospective job. Employers in your
field may have particular expectations for what should be on your résumé or how it
should be structured. Maybe you should list your skills or perhaps your education

first. Perhaps it would be preferable to list your past employment experiences in

reverse chronology (with your most recent job first). Advice is plentiful about how
to write a résumé, but there is no one right way or best way. Choose an appropriate
style and format for your job category that will present you in the best possible
light as a prospective employee.
Many employers want you to fill out an application form independently of or

instead of a résumé. They may also ask for references, especially from former
employers who are willing to recommend you. Be aware that hirers and human
resources department personnel routinely follow up on references and letters of
recommendation. Find out more about filling out employment applications at
About.com at http://jobsearch.about.com/cs/jobapplications/a/jobapplication.htm
and other sites.
There are many resources available in print and online to help you write a good
résumé. In addition, résumé writing workshops and short courses are often held at
community colleges or adult education centers.Ellen Gordon Reeves, Can I Wear My
Nose Ring to the Interview? (New York: Workman Publishing, 2009).
Selling Yourself: Your Interview
The interview—a face-to-face conversation with a prospective employer—is your

chance to get an offer. You want to make a good personal impression: dress
professionally but in clothes that fit well and comfortably. Be polite and cordial but
also careful not to assume too familiar a tone.
You may be asked a series of predetermined questions, or your interviewer may let
the conversation develop through open-ended questions. The interviewer may let
you establish its direction in order to learn more about how you think. However the
conversation is guided, you want to be able to showcase your suitability for the job
and what you bring to it. Figure 18.8 "Questions Prospective Employers Commonly
Ask" identifies some questions employers commonly ask in job interviews.

Figure 18.8 Questions Prospective Employers Commonly Ask
Be prepared for interviewers who prefer to focus on general behavioral questions

rather than on job specific questions. Behavioral interviews5 emphasize your past
actions as indicators of how you might perform in the future. The so-called STAR
Method6 is a good approach to answering behavioral questions, as it helps you to be
systematic and specific in making your past work experiences relevant to your
present job quest. The STAR MethodThe STAR Method: http://web.mit.edu/career/
www/guide/star.html, http://www.drexel.edu/SCDC/resources/
STAR%20Method.pdf, http://www.officearrow.com/home/articles/
the_officearrow_career_center/human_resources_and_job_search/p2_articleid/
294/p142_id/294/p142_dis/3 (accessed August 5, 2009). is a process of conveying
specific situations, actions, and outcomes in response to an interviewer’s question
5. A common type of job about something you did.
interview in which the
candidate is asked about past
behavior in a specific set of • Situation: Give specific details about the situation and its context.
circumstances. • Task: Describe the task or goal that arose in response to the situation.
6. A popular method of preparing • Action: Describe what you did and who was involved.
narratives for behavioral • Result: Describe the (positive) outcome.
interviews by referring to job
situations, tasks, actions, and
results. For example:

Question: We are looking for someone who is willing to take initiative in keeping our
office systems working efficiently and who can work without a lot of direct
supervision. Does that describe you?
Answer: Absolutely. For example, in my last job I noticed that the office supply
system was not working well. People were running out of what they needed before
letting me know what to order (Situation). I thought there needed to be a better
way to anticipate and fill those needs based on people’s actual patterns of use
(Task). So, I conducted a poll on office supply use and used that information to
develop a schedule for the automatic resupply of key items on a regular basis
(Action). The system worked much more smoothly after that. I mentioned it in my
next performance review, and my boss was so impressed that she put me in for a
raise (Results).
There are some questions employers should not ask you,

however. Unless the information is a legal requirement Figure 18.9
for the job you are interviewing for, antidiscrimination
laws make it illegal for an employer to ask you your age;
your height or weight; personal information such as
your racial identity, sexual orientation, or health; or
questions about your marital status and family
situation, such as the number of children you have,
whether you are single, or if you are pregnant or
planning to start a family.
It is also important for you to have questions to ask in

an interview, so you should prepare a few questions for
your interviewer. Questions could be about the
company’s products or services, the company’s mission
or goals, the work you would be doing, who you would © 2010 Jupiterimages
be reporting to, where you would be located, and the Corporation
opportunities for advancement. You want your question
to be specific enough to show that you have already
done some research on the company, its products, and
markets. This is a chance to demonstrate your
knowledge of the job, company, or industry—that you have done your
homework—as well as your interest and ambition.
Unless your interviewer mentions compensation, don’t bring it up. Once you have
the job offer, then you can discuss compensation, but in the interview you want to
focus on what you can do for the company, not what the company can do for you.

You can also use the interview to learn more about the company. Try to pick up
clues about the company’s mission, corporate culture, and work environment. Are
people wearing business attire or “business casual”? Are there cubicles and private
offices or a more open workspace? Are people working in teams, or is it more of a
conventional hierarchy? You want to be in a workplace where you can be
comfortable and productive. Be open-minded—you may be able to work quite well
in an environment you have never worked in before—but think about how you can
do your best work in that environment.
After your interview, send a thank you note, and follow up with a phone call if you
don’t hear back. You may ask your interviewer for feedback—so that you can learn
for future interviews—but don’t be surprised and be gracious, if you don’t get it.
Always leave the door open. You never know.
Accepting an Offer
A job offer should include details about the work you will be performing, the
compensation, and the opportunity to advance from there. If any of that
information is missing, you should ask about it.
In many jobs, you may be asked to do many things, especially in entry-level jobs, so
the job description may be fairly vague. Your willingness to do whatever is asked of
you (within the law and according to ethical standards) should be compensated by
what you stand to gain from the job—in pay or in new knowledge and experience or
in positioning yourself for your next job. Some jobs are better looked at as a kind of
graduate education.
Your compensation7 includes not only your wages or salary but also any benefits
that the employer provides. As you read in previous chapters, benefits may include
health and dental insurance, disability insurance, life insurance, and a retirement
plan. Compensation also includes time off, sick days, and vacation days. You should
understand the company’s policies and flexibility in applying them.
Know what your total compensation will be and whether it is reasonable for the job,
industry, and current job market. Asking around may help, especially on online
discussion groups with relative anonymity. People often are reluctant to disclose
their compensation, and companies discourage sharing this information because it
typically reveals discrepancies. For example, people hired in the past may be
7. Payment for labor, including receiving less (or more) pay than people hired recently for the same position. In
wages, salaries, commissions,
stock options, and fringe
addition, gender gap—in which men receive higher pay than women in the same
benefits such as health, position—is often a problem.
disability, and life insurance.

To gauge how reasonable a job offer is, you can research professional associations
about pay scales or find statistical averages by profession or region. Online
resources include simple salary comparison calculators, such as the one at
http://monster.salary.com. You also will find data and related articles linking
salaries to specific job titles, area codes, states, educational levels, and years of work
experience, for example, at http://www.payscale.com/research/US/
Country=United_States/Salary.
Realistically compare the job offer to your needs. Different geographic areas have
different costs of living, for example, so the same salary may afford you a very
different lifestyle in Omaha than in New York City. Your employment compensation
is most likely an important source—perhaps your only source—of income. That
income finances your plan for spending, saving, and investing. A budget can help
you to see if that income will be sufficient to meet your financial goals. If you
already have financial responsibilities—student loans, car loans, or dependents, for
example—you may find that you can’t afford the job.
You can negotiate your compensation offer; many employers expect you to try, but
some will just stand by their offer—take it or leave it. Your ability to negotiate
depends in part on the number of candidates for that particular job and how
quickly the employer needs to fill it. You will find guidelines online for evaluating
job offers and negotiating your compensation, for example, among the useful links
at http://www.rileyguide.com/offers.html. Another resource includes the simple
“Job Offer Checklist” at http://www.collegegrad.com/offer.
In some cases, your employer may offer you a contract, a legal agreement that
details your responsibilities and compensation and your employer’s responsibilities
and expectations. As with any contract, you should thoroughly understand it before
signing. If you will be employed as a member of a trade union or labor union under
a collective bargaining8 agreement, the terms of the contract may be applicable to
all union members and therefore not negotiable by individual employees.
It is exciting to get a job offer, but don’t let the excitement overwhelm your good
sense. Before you accept a job, feel positive that you can live with it. You never
really know what a job is like until you do, but it is better to go into it optimistically.
When you are just starting a career or trying one out, it is most important to be able
to learn and grow in your job, and you may have a period of “paying your dues.” But
if you are really miserable in a job, you won’t be able to learn and grow, no matter
8. The practice of union and
employer representatives how “golden” the opportunity is supposed to be.
negotiating an employment
contract to determine wages,
hours, work rules, and working
conditions.

KEY TAKEAWAYS
• Venues for finding jobs include
◦ trade magazines,
◦ professional organizations or their journals,
◦ career fairs,
◦ employment agencies or “headhunters,”
◦ employment Web sites,
◦ company Web sites,
◦ government Web sites,
◦ your school’s career development office.
• Networking is a valuable way to expand your job search.
• Selling your labor to a prospective employer usually involves

sending a cover letter and résumé, filling out an application
form, and/or having an interview.
◦ The cover letter should get a prospective employer to read

your résumé.
◦ The résumé should get the employer to offer you an
interview.
◦ The interview should get the employer to offer you the job.
• A job offer includes information on the
◦ job;
◦ compensation, including benefits;
◦ opportunities for advancement.
• Accepting a job offer may involve
◦ evaluating the offer in relation to your needs,

◦ examining a job contract, or
◦ negotiating the compensation.

EXERCISES
1. Read “Tomorrow’s Jobs” at the Bureau of Labor Statistics Web site at

http://www.bls.gov/oco/oco2003.htm. What job categories are showing
the greatest growth? Which job categories show negative growth? In
what sector of the economy or in what industry will you seek a job or
develop your career? Record or chart your thoughts in My Notes or your
personal finance journal. What are the reasons for your choices? What
education, knowledge, skills, aptitudes, preferences, and experiences do
you bring to them?
2. In My Notes or your personal finance journal, list all the individuals and
groups you can think of to tell about your job search or career
development quest. Include their contact information. Write a message
you could adapt, as needed, for each audience to send when you are
ready. Then go online to research other individuals and groups you
could include in your networking or could go to for more information
about job opportunities. Read up on developing your practical
networking skills online at Boston.com (“Flex Your Networking Skills,”
http://www.boston.com/jobs/bighelp2009/january/
flex_your_network). Make a fact-finding appointment with a contact
you find through networking and record your thoughts on the
outcomes. Were you able to practice key networking skills? What did
you learn?
3. Write or revise your résumé and draft a general cover letter you could
adapt for different job openings. Network with classmates to get
critiques and ideas for clarifying or improving these tools to attract a
prospective employer. What other supporting documents could you
include in your job application?
4. How will you prepare for a job interview? Read a New York Times
interview with the CEO of Cisco Systems, John Chambers, about
corporate leadership and recruitment at
http://www.nytimes.com/2009/08/02/business/
02corner.html?th&emc=th. In the second half of the article, the
interviewer asks, “How do you hire?” What qualities of new
recruits to corporate management does this CEO look for? Read
the articles on interviewing at the following Careerbuilder.com
URLs:
◦ http://www.careerbuilder.com/jobposter/small-business/
article.aspx?articleid=ATL_0174INTERVIEWBLUNDERS

article.aspx?articleid=ATL_0089INTERVIEWSTYLES
article.aspx?articleid=ATL_0087INTERVIEWNO-NOS
article.aspx?articleid=ATL_0082INTERVIEWQUESTIONS
5. Anticipate the questions you may be asked in an interview. For example,
what could you say in a behavioral interview? Prepare your answer
using the examples found at http://webatl02.officearrow.com/job-
search/the-star-method-of-interviewing-oaiur-107/view.html. For
edification and fun, collaborate with classmates to do role-plays of job
interviews. Videotape your interviews. View the videos and read the
twenty tips on “How to Nail an Interview” at
http://www.howtonailaninterview.com/#vid. Also see the Vault.com
videos of interviews at http://www.youtube.com/
watch?v=S1ucmfPOBV8. As an employer, would you hire yourself? What
interviewing preparations and skills do you think you need to work on?

18.3 Leaving a Job
LEARNING OBJECTIVES
1. Describe the processes of voluntary job loss.

2. Describe the processes of involuntary job loss.
3. Identify the financial impacts of an involuntary job loss.
4. Identify major federal legislation that addresses employment issues and
describe its importance in labor markets.
Statistically, it is almost impossible for you to expect to have one job or career for
your entire working life. At least once and possibly many times, you will change
jobs or even careers. You will have to leave your current or former job and find
another. Handling that transition can be difficult, especially if the transition is not
what you would have preferred. How you handle that transition may affect your
success or satisfaction with your next position.
You may leave your job voluntarily or involuntarily. When you leave voluntarily,
presumably you have had a chance to make a reasoned decision and have decided
that the net benefits of moving on are more than the net benefits of staying.
Leaving Voluntarily
You may decide to leave a job and move to another for the following reasons:
• move to a position with more responsibility, opportunity to advance,

or compensation
• be in a more compatible work environment or corporate culture
• learn a new skill
• become self-employed by beginning an entrepreneurial venture
• make a transition from a military to a civilian job
In other cases, you may leave employment permanently or temporarily because of

the following reasons:
• further your education

• assume family care, for example of a child or parent
• take time off for recreation
562
• retire
Whatever your motivation for leaving your job, your decision should make sense;
that is, it should be based on a reasoned analysis of how it will affect your life. If you
have dependents, you will have to consider how your decision may affect their lives
too.
Since your job is a source of income, leaving your job means a loss of that income.
You need to consider how you can maintain or change your current use of income
(i.e., spending and saving levels) with that loss.
If you are changing jobs, your new job will replace that income with new income
that is more than, equal to, or less than your old paycheck. If it is equal to or more
than your former income, you may maintain or even expand your spending, saving,
and investing activities. Extra income will provide you with more choices of how to
consume or save. If it is less than your former income, you will have to decrease
your spending or saving to fit your current needs. Your budget can help you foresee
the effects of your new income on your spending and saving.
If you are leaving employment, then there will be no replacement income, so your
spending and saving activities should reflect that loss, unless you have an
alternative source of income to replace it. If you are going on to graduate school,
perhaps you have a fellowship or scholarship. If you are assuming family care
responsibilities, perhaps another family member has offered financial support. If
you are retiring, you should have income from invested capital (e.g., your
retirement savings) that can be used to replace your wages or salary.
If you are initiating the job change, be sure you try to cause the least disruption and
cost to your employer. Let your employer know of your decision as soon as is
practical, and certainly before anyone else in the company knows. “Two weeks
notice” is the convention, but the more notice you can give, the less inconvenience
you may cause. Offer to help train your successor or be available to provide
information or assist in the transition. The more cordially you leave your job, the
better your relationship with your former employer will be, which may reflect well
on you in future networking.
If you participated in a defined contribution retirement plan you own those funds
to the extent that you are vested in your employer’s contributions and have
contributed your own funds. You can leave those funds as they are invested, or you
can transfer them to your new job’s plan and invest them differently. There may be
some time limits to doing so, and there may be tax considerations as well, so be sure
18.3 Leaving a Job 563

you consult with your former employer and understand the tax rules before moving
any funds.
The decision to leave a job and perhaps to leave employment means leaving
nonincome benefits that can create opportunity costs, including
• intellectual or emotional gratifications of the work,

• enjoyment of your colleagues,
• opportunities to learn.
If you have had a negative work experience, leaving may allow you to reduce
boredom, eliminate job dissatisfaction, end conflict, avoid unwanted overtime, or
reduce stress, but these are reasons for leaving a job that you probably should not
share with a new or prospective employer.
Surveys reported in 2005 had this to say about job

satisfaction in the United States:Job Satisfaction, Figure 18.10
http://www.careervision.org/About/PDFs/
MR_JobSatisfaction.pdf, http://www.conference-
board.org/utilities/pressdetail.cfm?press_id=2582
(accessed July 21, 2009).
• Job satisfaction generally declined since

2000.
• Forty-five percent of workers say they are
either satisfied or extremely satisfied with
their jobs.
• Twenty percent feel very passionate about
their jobs.
• Thirty-three percent believe they have
reached a dead end in their career. © 2010 Jupiterimages
• Twenty-one percent are eager to change Corporation
careers.
• Older workers are the most satisfied and
the most engaged in their work.
• Younger workers are the most distressed
and feel the least amount of loyalty to their employers.
• Small-firm employees feel far more engaged in their work than their
corporate counterparts.
• Job security, health care coverage, and professional development are
valued above additional compensation.

According to a 2009 Salary.com survey, only around 15 percent of workers said they
were “extremely satisfied” with their jobs. Working retirees and those in the health
care and Internet industries were the most satisfied, while workers under thirty
and those working in finance-related fields were the least satisfied. At the time of
the survey, about 60 percent of workers were looking around for another job,
despite most claiming they were generally satisfied with their wages or salaries.
Many were worried about being laid off in a down
economy.http://www.salary.com/personal/layoutscripts/
psnl_articles.asp?tab=psn&cat=cat011&ser=ser032&part=par1352 (accessed August
5, 2009).
As you can see, many micro and macro factors may enter into a decision to leave a
job. You spend many of your waking hours working, and deciding to change jobs is
about much more than just income. It is still a decision about income, however, so
you should carefully weigh the effects of that decision on your personal financial
well-being.
Leaving Involuntarily
If you leave your job involuntarily, you will have to make adjustments for a loss of
income that you were not planning to make. That may be difficult, but not so much
as you think.
Involuntary job loss may be due to your employer’s decision, an accident or

disability, or unexpected circumstances, such as the acquisition, merger,
downsizing, or closing of the company you work for. Your employer also may
decide to lay you off or fire you. A layoff implies a temporary job loss due to a
circumstance in which your employer needs or can afford less labor.
If the layoff is due to an economic recession when there is less demand for the
product you create, then it may be affecting your entire industry. That would mean
you would have a harder time finding a similar job. If layoffs are widespread
enough, however, there may be federal, state, or local government programs aimed
at helping the many people in your situation, such as a retraining program or
temporary income assistance.
You may get laid off because your employer is no longer as competitive or
profitable and so has to cut costs or because the company has lost financing. If the
layoffs are specific to your employer, you may be able to find a similar position with
another company or you may be able to establish your own competitive business in
the same industry.

When you are fired, the employer permanently terminates your employment based
on your performance. Involuntary termination9, or getting fired, will cause a
sudden loss of income that usually requires sudden adjustments to spending and
saving. You may have to use your accumulated savings to finance your expenditures
until that income can be replaced by a new job.
An injury or illness—to you or a dependent—may create a temporary or permanent

involuntary job loss. It usually also means a period of unemployment. Depending on
the circumstances, your employer may be willing to help ease the transition,
perhaps by offering you a more flexible schedule, adjusting your responsibilities, or
providing specialized equipment to enable you to do a job.
By law, employers may not discriminate against people with disabilities so long as
they are able to do a job. A job accommodation10 is any reasonable adjustment to a
job or work environment that makes it possible for an individual with a disability to
perform or continue to perform job duties.
If you become disabled and unable to work, you may be able to replace some or all
of your wage income with insurance coverage, if you have disability insurance that
covers the specific circumstances (as discussed in Chapter 10 "Personal Risk
Management: Insurance"). If your disability is permanent, you may qualify for
federal assistance through Social Security. If someone else is liable for your
disability, in the case of an accident or through negligence, his or her insurance
coverage may provide some benefit, or you may have a legal claim that could
provide a financial settlement.
If your employer initiates your job change, be sure to discuss his or her obligations
to you before you leave. Some employer responsibilities are prescribed by law, as
shown in Figure 18.11 "Major U.S. Employment Legislation". Other responsibilities
9. The ending of an employment are prescribed by union contract, if applicable, and some are conventions or
relationship; termination may courtesies that your employer may—or may not—choose to extend.
be initiated by the employee
(voluntary), the employer
(involuntary), or mutually Severance11 is compensation and benefits offered by your employer when you are
agreed upon by both.
fired. Your employer is not obligated to offer any severance, but “two weeks pay” is
10. A provision of the Americans the convention for wages. Your employer is also not required to “pay” for your
with Disabilities Act of 1990 remaining sick days or vacation days or to extend your benefits, including
that employers make
retirement contributions or life insurance, unless specified in a contract. In most
“reasonable accommodations”
for employees with defined cases, your employer is required under federal law to offer you the opportunity to
disabilities so as not to remain covered under your employee health insurance plan if you assume the cost.
discriminate against them. This continuation of health coverage is provided by COBRA, the Consolidated
11. Compensation upon dismissal Omnibus Budget Reconciliation Act of 1986 (discussed in Chapter 10 "Personal Risk
from employment. Management: Insurance"). Employers must also provide proof of “insurability,”

which enables unemployed workers to purchase private health insurance, if they

wish, without having to undergo medical exams.
Employment Protection
Federal and state laws govern relationships between employers and employees. A
large part of employment law addresses hiring and firing issues as well as working
conditions. You should be familiar with the laws that apply where you work (as they
differ by state and sometimes by county) so that you understand your
responsibilities to your employer and your employer’s obligations to you.
Major federal legislation that addresses these issues is outlined in Figure 18.11
"Major U.S. Employment Legislation".
Figure 18.11 Major U.S. Employment LegislationU.S. Department of Labor, “Summary of the Major Laws of the
Department of Labor,” http://www.dol.gov/opa/aboutdol/lawsprog.htm (accessed July 21, 2009).
12. A legal term to describe a These laws cover all aspects of employment: hiring, negotiation, working
termination by the employer conditions, compensation, benefits, and termination. Workers can sue a company
that violates the employment for wrongful discharge12—for being fired for any reason barred by an employment
contract or the law.

law. Employers often seek to protect themselves from suits by requiring terminated
employees to sign a form releasing the company from liability.
Companies have ethical standards for dealing with the hiring and firing of
employees, but they also may have informal practices for encouraging unwanted
employees in good standing to leave. Employment laws cannot protect workers
against some unethical practices, but they have clauses that prohibit retaliation13
against employees who invoke those laws or enlist government assistance to
enforce them. The laws also protect whistleblowers14 who report employer
infractions to government authorities.
The federal government provides unemployment compensation insurance through

the Federal-State Unemployment Insurance Program to employees who “lose their
jobs through no fault of their own.”U.S. Department of Labor, “Unemployment
Insurance,” http://www.dol.gov/dol/topic/unemployment-insurance/index.htm
(accessed July 21, 2009). You must meet eligibility requirements to qualify, and the
benefits are limited, although they may be extended in certain circumstances.
Benefits were extended in February 2009, for example, to as long as seventy weeks
in many states, as the number of unemployed workers rose to six million.
Your job and eventually your career will play many roles in your life. It will
determine how you spend your time, who you spend your time with, where you
live, and how you live. It will probably be a primary determinant of income and
therefore of how much you can spend, save, and invest. How you chose to spend,
save, and invest is up to you, and your financial decisions can have far-reaching
consequences. The more you know and the more you understand, the more you can
make decisions that can satisfy your dreams.
13. Actions by an employer to

punish an employee who has
complained of employer
misconduct to authorities.
14. An employee who alerts

authorities to possible
employer misconduct.

KEY TAKEAWAYS
• You can expect to leave a job at least once in your career.

• You can leave a job voluntarily or involuntarily.
• You may leave voluntarily to change jobs or to leave employment,
temporarily or permanently.
• You may leave a job involuntarily through a
◦ layoff,
◦ disabling accident or injury,
◦ firing.
• Leaving a job involuntarily means a sudden loss of income.
• Involuntary job loss may be compensated with
◦ severance,
◦ employment insurance,
◦ continuation of health and other benefits.
• Federal, state, and local laws address employment issues, including
hiring, working conditions, compensation, and dismissal. Laws exist to
protect workers.

EXERCISES
1. What do you look for in a job? Record in My Notes or your personal

finance journal the characteristics of a job that you value most when
seeking a job and the characteristics that bother you the most or would
cause you to consider leaving a job voluntarily. Take an online job
satisfaction survey or collaborate with classmates to develop questions
for a job satisfaction survey that you can administer to other students.
What do you find are the top ten characteristics of a great job offering a
lot of job satisfaction?
2. View the list of “Red Light” reasons for leaving a job—reasons you
should not use in a job interview in which you are asked why you left
your last job—at http://www.career-advantage.net/Training/
reasons_for_leaving_a_job.html. Have you ever cited one of those
reasons as the reason you left your job? For each item on the list,
brainstorm with classmates why it would be better not use it in a job
interview. What does the item say about you as a worker or as an
employee? What could you possibly do differently to prevent each “Red
Light” item from being the reason you leave a job?
3. Record in My Notes or your personal finance journal the outcome of
every job you have held. For each job, have a column for listing your
reason(s) for taking it and another column listing your reason(s) for
leaving it. Also, note what you liked most and least about each job. Do
you notice any patterns emerging in the data about your job history? Is
there anything about those patterns that you would like to change?

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Individual Finance

This book is licensed under a Creative Commons by-nc-sa 3.0 (http://creativecommons.org/licenses/by-nc-sa/

Rachel S. Siegel, chartered financial analyst (CFA), has

Originally from Providence, Rhode Island, Siegel earned a BA in English literature

Carol Yacht, Business Educator and Author

Carol Yacht is a business educator and textbook author.

Yacht teaches Accounting Information Systems at the University of South Florida

The text may be divided into five sections:

1. Learning Basic Skills, Knowledge, and Context (Chapter 1 "Personal

3. Protecting What You’ve Got (Chapter 10 "Personal Risk Management:

Learning Basic Skills, Knowledge, and Context (Chapter 1 "Personal Financial

Chapter 1 "Personal Financial Planning" introduces four of its major themes:

• Financial decisions are individual-specific (Section 1.1 "Individual or

These themes emphasize the idiosyncratic, systemic, and continuous nature of

Chapter 3 "Financial Statements" continues with the discussion of organizing

Chapter 5 "Financial Plans: Budgets" demonstrates how organized financial data

Getting What You Want (Chapter 7 "Financial Management"–Chapter 9

Chapter 7 "Financial Management" focuses on financing consumption using current

Chapter 8 "Consumer Strategies" discusses purchasing decisions, starting with

Protecting What You’ve Got (Chapter 10 "Personal Risk Management:

Chapter 10 "Personal Risk Management: Insurance" introduces the idea of

Chapter 11 "Personal Risk Management: Retirement and Estate Planning" focuses

Building Wealth (Chapter 12 "Investing"–Chapter 17 "Investing in Mutual

Chapter 12 "Investing" presents basic information about investment instruments

Chapter 14 "The Practice of Investment" looks at the mechanics of the investment

Chapter 15 "Owning Stocks", Chapter 16 "Owning Bonds", and Chapter 17

How to Get Started (Chapter 18 "Career Planning")

Tomika is getting a Bachelor of Science degree in medical technology and hopes to

1. What individual or personal factors will affect Tomika’s and Bryon’s

1.1 Individual or “Micro” Factors That Affect Financial Thinking

1. List individual factors that strongly influence financial thinking.

The circumstances or characteristics of your life influence your financial concerns

Marital status and dependents, such as children, parents, or siblings, determine

1.1 Individual or “Micro” Factors That Affect Financial Thinking 15

Figure 1.1 Median Salary Comparisons by ProfessionBased on data from http://www.careeroverview.com/

1.1 Individual or “Micro” Factors That Affect Financial Thinking 16

As your career progresses, income increases but so does spending. Lifestyle

As income, spending, and asset base grow, ability to

1.1 Individual or “Micro” Factors That Affect Financial Thinking 17

Figure 1.3 Financial Decisions Related to Life Stages

Later adulthood is a period of spending down. There is less reliance on earned

Effective financial planning depends largely on an awareness of how your current

1.1 Individual or “Micro” Factors That Affect Financial Thinking 18

• Personal circumstances that influence financial thinking include family

1. Use Flat World’s My Notes feature to start keeping a written record of

1.1 Individual or “Micro” Factors That Affect Financial Thinking 19

1.2 Systemic or “Macro” Factors That Affect Financial Thinking

1. Identify the systemic or macro factors that affect personal financial

9. Recurring periods of economy- Employment Rate

1.2 Systemic or “Macro” Factors That Affect Financial Thinking 21

The unemployment rate10 is a measure of an

Figure 1.6 Cyclical Economic Effects

10. A measure of the percentage of

1.2 Systemic or “Macro” Factors That Affect Financial Thinking 22

Other Indicators of Economic Health

1.2 Systemic or “Macro” Factors That Affect Financial Thinking 23

A hedge against lost wages is investment to create other forms of income. In a

Stable currency value is another important indicator of a healthy economy and a

1.2 Systemic or “Macro” Factors That Affect Financial Thinking 24