Can you use an example to explain how time value of money can be applied to your

Question

Can you use an example to explain how time value of money can be applied to your personal money management? Compare the difference between bonds and common stocks. If your investment portfolio only includes bonds and stocks, what percentage of your investment will be bonds and what percentage of your investment will be stocks? Why?

Explanation / Answer

Theory Of Time Value of Money: a dollar can be invested and earn interest over time, giving it potential earning power. Also, money is subject to inflation, eating away at the spending power of the currency over time, making it worth less in the future. Finally, there is always the risk of not actually receiving the dollar in the future - if you hold the dollar now, there is no risk of this happening. Getting an accurate estimate of this last risk isn't easy and, therefore, it's harder to use in a precise manner. Illustration And Example:Time value of money and Personal money management The time value of money is a simple principal to understand: basically it states that any amount of money is worth more today than the same amount of money in the future due to it’s earning potential. This means that if you have $100 to invest today, it’s worth more than $100 a year from now, because it could be gaining value through investments for a year. Let’s assume you average 9% on your investments… Your $100 today will be worth $109 in a year, whereas getting $100 a year from now is only worth about $91, due to the value of money lost in the year. Personal Money Management: Basically what it states is that when Saver B starts investing earlier on in life, the time value of his money allows for gaining potential so much greater that even though Saver A invested more than 4 times the amount of Saver B, Saver B has gained more than $400k more than Saver A by retirement. Moral of the story -> If you start investing now, you’ll have much more than if you wait till you make more money, even if you invested more in the years to come. Understanding an Individual Common Stock: The purchase of common stock represents ownership in a company. People who own individual stocks are commonly referred to as shareholders of the company. If the common stock is of a publicly traded company, like Microsoft, then you, as a shareholder, will usually have voting rights as a company owner. Unfortunately, if you own a mutual fund that contains individual common stocks, you will not be considered a company owner; therefore, you will have no voting rights because the mutual fund company is the owner of those shares of stock. The value of the stock increases or decreases based on the supply and demand of the individual common stock. When a company shows strong earnings or the future earnings appear to be bright, more people are likely to demand the stock. In many cases, this will drive the price of the stock higher. On the other hand, if a company misses its earning estimates or its corporate executives have engaged in illegal activities, it is not uncommon to watch the price of the stock fall, as the demand for the stock decreases. However, in most cases, investors of an individual stock desire for the stock price to go up. A stock company also can reward an investor by offering a dividend, which is paid on a per share basis. The company can declare a dividend for investors of record on a specific date; for example, you must own the stock on January 3, 2008, in order to receive the $2.00 per share dividend. Keep in mind, companies are not required to pay dividends, and many of the common stocks that trade daily do not. Common Stocks And Bonds: Stocks (aka Equities): Stocks represent partial ownership of a corporation. If the corporation does well, its value increases, and you share in the appreciation. However, if the corporation goes bankrupt, you can lose your entire initial investment. Bonds (aka Notes): Bonds represent a loan you make to a corporation or government. For example, you can buy a US Treasury bond for $100, and get a guaranteed interest rate for 5-years, and can expect to get your $100 back at the end of that 5-years plus interest. Your risk is repayment of the principal (amount invested). Because loaning $100 to the U.S. government is much less risky than loaning $100 to the Brazilian government, U.S. government bonds pay a much lower rate of interest ("coupon") for borrowing your money. Understanding an Individual Bond: An individual that purchases a bond is not an owner of the company, but is a debtor. As a bondholder, you have lent money to the borrower, for a specific period of a time, with the expectation of the entity paying you interest when due and your principal at maturity. The company, government or other entity is obligated to pay the bondholder; otherwise, the entity is considered to be in default. When the bond matures, you will receive the face amount of the bond. In addition, many bonds pay interest to their bondholders on a bi-annual basis. The amount of interest the bondholder receives on a yearly basis is based on the bond’s face amount multiplied by the bond’s stated interest, which is commonly referred as the coupon rate. For example, exactly one year ago, you bought a bond with a $1000 face amount and 6% coupon rate. Twice a year, the bond issuer will send you a check for $30 ($1000 x ½ 6% = $30 twice a year) until the bond matures. As a bondholder, you usually have the right to sell the bond in the secondary market. Sometimes, interest rates begin to fall, and when they fall, the price of bonds usually rises. When the price of the bond is higher than its face amount, the bond is said to be trading at a premium, or above par value. In some cases, bond investors will sell their bond in the secondary market if the price of the bond is higher than its face amount; however the bond’s years to maturity and its coupon rate need to be considered. Differences Summary: Summary of Stocks 1. Common stockholders - owners of the company 2. Hope the price of the stock appreciates in value; look for good corporate news 3. Some companies pay dividends, usually in the form of cash – taxable in the year distributed 4. Dividends are not mandatory 5. Common stocks have no maturity date 6. The stockholder will realize a capital gain or loss when the stock is sold, in most cases Summary of Bonds 1. Bondholders have lent the corporation, government, or entity a sum of money 2. The bond will eventually mature 3. In the meantime, the bondholder usually receives an interest payment on a bi-annual basis 4. Some bondholders want interest to drop in order to sell their current bonds at a profit 5. If a company folds, bondholders must be paid before common stockholders 6. If there are bonds within a mutual fund, your mutual fund company will be considered to be the bondholder My investment Portfolio: Moderately Aggressive Allocation: 80% Stocks, 20% Bonds Because:I want to target a long-term rate of return of 8% or more.I must expect that at some point I will experience a single calendar quarter where my portfolio is down as much as -20%, and perhaps even an entire calendar year where my portfolio is down as much as -40%. That means for every $10,000 invested, the value would drop to $6,000. You must rebalance this type of allocation about once a year. Best Wishes.

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