ln4_investing - Lecture 4 Investing I Why Invest To...

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1 Lecture 4: Investing I. Why Invest? To transfer resources to the future and at least keep pace with inflation. Inflation erodes the purchasing power of dollars - if keep "money in a mattress", it loses value. II. What Do You Look for When You Invest? Want to earn the highest real interest rate (nominal or observed interest rate minus inflation rate) for the level of risk you're willing to take. Example of real interest rate Nominal, or observed, interest rate = 10% Inflation rate = 4% Real interest rate = 6% Risk = chance of losing your invested money Reality: Risk and real interest rate (also called "real rate of return") usually go together: the greater the chance you're willing to take with your investments, the higher the potential reward you must receive Impact of taxes: Taxes come "off the top" - they are charged on the nominal interest rate. The "after-tax" nominal interest rate would be calculated as: nominal rate - (tax rate x nominal rate) Example: Nominal rate = 10% Tax rate = 30%, or .3 After-tax nominal interest rate = 10% - (.3 x 10%) = 7% Then, can also talk about real after-tax interest rate , where take After-tax nominal interest rate and subtract the inflation rate: After-tax nominal interest rate = 7% Inflation rate = 4% Real after-tax interest rate = 3% III. Basic Kinds of Investments Stocks = ownership of net assets of a company Inflation hedges = real estate, precious metals, collectibles Cash = investments easily convertible to cash, like money-market funds and very short term CDs (certificates of deposit)
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2 Long-term bonds = investments earning a fixed interest rate over a long period Each investment has performance tied to stages of the business cycle, as shown
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ln4_investing - Lecture 4 Investing I Why Invest To...

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