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In comparison, the stock market has an average annual return of 10%. This also does not include any cost of living increases or other raises. However, this assumes that you graduate from college, as the higher salaries above are for college graduates.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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For-profit colleges (like University of Phoenix, Corinthian Colleges, and Strayer University) and for-profit training schools (like ITT Technical Institute and Education Management Corporation) are some of the biggest culprits of student debt abuse. These organizations accounted for about 40% of all student loan defaults while only representing about 11% of all loans. According to a 2014 report by The Institute for College Access and Success, a student is three times as likely to default at a for-profit school than at a 4-year public or non-profit college; further, they are almost four times as likely to default than at a community college (see reports on ticas.org). One-third of college students drop out entirely. More than half of the students enrolled in college take more than 6 years to graduate.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_346_100

For-profit colleges have abysmal graduation rates. Sixty-seven percent of students at not-for-profits have graduated after six years, while the same is true for only 23% of students at for-profit schools. Dropouts are then saddled with student debt but still stuck at the same salary level as before going to college. Because these schools are motivated by profit, they admit less qualified students and offer less support. Beginning in the 1980’s, government student loans led to a massive expansion of for-profit educational institutions. However, the Obama administration cracked down on for-profit schools with the worst graduation rates, denying them the ability to qualify for federal student loans. As a result, their revenue declined precipitously. For example, the University of Phoenix revenue declined 70%, and Corinthian College declared bankruptcy.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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The government will pay the interest on federal loans if you qualify based on income while you are in school. When you stop going to school, you must start paying back the loan. There are four types of student loans from the U.S. Department of Education:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Direct Subsidized Loans are loans made to eligible undergraduate students who demonstrate financial need to help cover the costs of higher education at a college or career school. (Maximum loan is $12,500 per year of schooling)

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_350_100

Direct Unsubsidized Loans are loans made to eligible undergraduate, graduate, and professional students, but eligibility is not based on financial need. (Maximum loan is $12,500 per year of schooling)

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Direct PLUS Loans are loans made to graduate or professional students and parents of dependent undergraduate students to help pay for education expenses not covered by other financial aid. Eligibility is not based on financial need, but a credit check is required. Borrowers who have an adverse credit history must meet additional requirements to qualify. (Maximum loan is $20,500 per year of schooling)

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_352_100

Direct Consolidation Loans allow you to combine all eligible federal student loans into a single loan with a single servicer.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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No one who understands the miracle of compound interest better than Warren Buffett, a multi-billionaire and Chair of Berkshire Hathaway, best known as the Sage of Omaha. [Nebraska] and Chair of Berkshire Hathaway. An article in The Wall Street Journal by Jason Zweig (8/28/20) details Buffett’s thinking about time and the value of money. Patience and endurance are the “investing superpowers” that helped him achieve his $82 billion of personal wealth:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_357_100

From the earliest age, Mr. Buffett has understood that building wealth depends not only on how much your money grows, but also on how long it grows. Around the age of 10, he read a book about how to make $1,000 and intuitively grasped the importance of time. In five years, $1,000 earning 10% would be worth more than $1,600; 10 years of 10% growth would turn it into nearly $2,600; in 25 years, it would amount to more than $10,800; in 50 years, it would compound to almost $117,400 (2020).

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_358_100

Because we will be discussing the time value of money, we will inevitably be discussing math in this chapter. However, it is not advanced math, so you should find it easy to understand.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Receiving a payment today is better than receiving one a year from now, in part because the general rate of inflation (e.g., two percent) makes the money worth less next year due to decreased purchasing power (that is, two percent less). It is also better if you are going to save or invest that money, putting it into a savings account at 3% interest (for example) means that in a year you will have an additional earning of 3% on top of the original amount. We can illustrate it in this equation:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_364_100

Pyear1 is the principal amount you received at the beginning of year one, and Pyear2  is the principal amount you will have at the beginning of year two, including the interest you earned. However, interest or dividends money in savings or an investment is compounded. That is, if you leave the interest or dividends you earned over year one in savings for year two, you will again receive 3% interest on the principal plus 3% interest on the interest you already earned in year one. We can represent this mathematically as follows: 

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Let’s say that you put $1,000 in a savings account at 3% interest and leave it to compound. Below, you can see the amounts you will have at the beginning of each year:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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The compounding of the interest may not seem like a lot here, but it makes a huge difference when you are saving for retirement. For another example, let’s say you start working at 21 and retire at 68, spending 47 years in the labor force. As we will discuss in more detail later, one investment in a mutual fund with a widely diversified portfolio saw a return of an average of 10.1% per year for ninety-four years. If you were to invest $1,000 in this diversified portfolio and did not touch it for 47 years, you would have a retirement nest egg that looked like this:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Original Amount: $1,000.00 at beginning of year 1 Interest Rate: 10.1% compounded Time Period: 47 years Amount at end of 47 years: $92,045.80

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Furthermore, you will most likely deposit more into your retirement account each year, rather than just $1,000 once at the beginning of your career. If you invested $1,000 per year each year in this diversified stock portfolio, at the end of your career your nest egg would look like this:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Principal Amount: $1,000.00 each year invested at the beginning of each year Interest Rate: 10.1% compounded Time Period: 47 years Amount at end of 47 years: $1,084,535.20

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Most of the time, if you work for a good employer, they will sponsor a 401(k) retirement plan and match your contributions. The most common plan is that you contribute 3% of your salary, and your employer matches. Let’s say that together you contribute $4,000 per year for 47 years and put it all in a diversified stock portfolio. In that case, here is your retirement nest egg:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Saving and borrowing allow intertemporal consumption. Basically, you move your consumption from one time period to another. If you do not spend all your income in year one, your savings can increase your consumption in later years. On the other hand, if you spend more than your income in year one (by using credit cards or taking out a personal loan), you must consume less than your income in subsequent years to pay back your debt. As the prime example of this, saving money for retirement each year means you are consuming less currently in order to have money for retirement. However, you are also earning interest or dividends that will allow you to consume even more than the original amount when you reach retirement.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Dr. Franco Modigliani, Nobel Prize winner in economics, explains our consumption and saving decisions over a lifetime with the life cycle hypothesis. Until college graduation, when we have student loans, we are dissaving; that is, we are consuming more than our income and financing it with student loans. After we begin our career, we consume less than we earn because we are saving for retirement. Finally, when we retire, we are once again dissaving by spending the retirement savings we have built up.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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However, you do not need to work out the future dollar value by hand. The internet offers lots of calculators that will do this for you.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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The present value of future dollars is called the Net Present Value (NPV), and it involves the economic principle of Opportunity Cost. The opportunity cost is the next best use for your money instead of your current purchase, or it can be the next best use of your time instead of what you are using it for now. For example, the opportunity cost of paying college tuition could be giving up on buying a new car. The opportunity cost of going to class could be getting a few more hours of sleep. The opportunity cost of not having a specific amount of money this year instead of next year is the interest or dividend you earn through investment.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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This concept is important in business because the principal way a business can value an investment is the stream of income the investment throws off, discounted to the present. This is called Net Present Value of Discounted Cash Flow.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_427_100

What interest rate (or discount rate) should you use to discount future streams of income? As a student, your opportunity cost would most likely be the 2% interest you would earn in a savings account. For business, the discount rate used is most often 8% or 10% per year because this is the return they would get by investing in their business if they had it now instead of later. 

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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If a company buys an investment that generates $100,000 per year for ten years. The discounted cash flow or net present value of this cash flow stream is

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Note that we are dividing the cash flow or income from each period by 1 plus the discount rate, so this is reducing the cash flow by the discount rate. There are many online calculators that you can use to calculate the Net Present Value of future cash flows.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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An annuity is simply a stream of money paid periodically. It could be interest from a savings account or dividends from a stock investment. The present or future value of an annuity can be calculated using the present or future value calculators presented above.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Financial innovation describes the changes in the types of institutions or services offered in the financial marketplace. Here are some financial innovations that have occurred recently:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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The expansion of investment banks into commercial banking ( e.g., Goldman Sachs now offers checking accounts and other services.)

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Owning a home has always been the American Dream. In fact, the rate of American home ownership has always been greater than in most European countries. Historically, the homeownership rate in the U.S. has ranged from 63% to 65%, going back to 1970. It rose to 69% just before the Great Recession, but then in 2015, as homes were foreclosed, it dropped all the way back down to 63%. Still, it remains a dream of most people to own their own home.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_461_100

There are two main factors to consider when trying to decide whether to buy or rent: how long you will be in a location and what your current financial situation is. You need to own a house at least three years to recover your transaction costs, and you should consider whether you can afford the down payment and the monthly mortgage costs. Also, be sure to check if you would be eligible for tax benefits. You can deduct the annual interest of your mortgage plus local real estate taxes. Generally, young people rent while in college, then rent in a downtown area after they get their first job, and then buy a home after they become a couple (especially if they have children). People under 25 tend to rent, as they are not yet locationally stable and because the mortgage interest tax deduction does not help them much. Between the ages of 25 to 55, people tend to buy. At any age, however, low-income people tend to rent due to economic barriers.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_463_100

When buying a home, you are buying into a school district, a government, and a neighborhood. Depending on the district, school quality (and associated taxes) can vary significantly and can be a major expense in owning a home. The government in your city or township may or not be interested in actively maintaining the infrastructure of the municipality, which can have an effect on road conditions and municipal taxes. Finally, you want a friendly neighborhood, and if you buy a house when you have children, you want other children for your kids to play with. When you have narrowed down your property choices, it pays to knock on a few doors to introduce yourself and ask about the neighborhood.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_464_100

When either renting or owning, you consume housing services. This is easy to understand with renting but might be a little harder to grasp when it comes to owning. A house is a durable good, or a good that lasts more than three years. A house provides you with housing services that you then pay for. The correct price for a durable good is not its purchase price but what is called its annual user cost: your annual out of pocket expenses. For a home, the user cost includes:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Sorry to tell you, but life is hard. You will have difficulties, and there will be accidents and events that affect your property or your health. To put it another way, life inherently contains risk. You and your family are at risk that you may be in an automobile accident. You and your family are at risk that one or several of you may become ill and require a hospital stay. You and your family are at risk that a tree may fall on your house. Of course, not all these risks have the same probability of occurring, and not all of these risks will incur the same amount of financial loss.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_476_100

Insurance companies take on your risk for a fee, known as a premium. By buying insurance, you are protecting your wealth and income against unexpected events that can take away your wealth or income. There are many types of insurance you can buy to protect yourself, your family, and your property:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Generally speaking, an investment is something you put time or money into and get a return from. For example, we talk about investing in a personal relationship. We also talk about investing in the stock market. For this chapter, we will use the financial definition of investing: a financial asset you contribute money to and from which you receive an interest payment, a dividend, or an increase in the market value over time (or all three). You use money from your savings to invest:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Keeping these equations in mind, it is hopefully apparent that the more disposable income you save, the more you are able to invest. But where to invest?

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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On Wall Street, the standard saying is “risk follows returns.” By choosing a lower risk investment (such as U.S. Treasury Bonds), you will receive a lower return. Treasury Bonds are considered the safest investment possible because the U.S. has always paid those bonds back (except for debts from the Revolutionary and Civil Wars, but that’s another story). Almost all long-term interest rates are influenced by the rate on the U.S. Treasury Bonds, which are considered a “risk-free” return.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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In terms of risk, the three traditional investment instruments are stocks, bonds, and cash. We can analyze each in terms of risks and rewards. On Wall Street, risk is measured by beta (the Greek letter β), which measures the volatility or deviation from the average historical return of an investment.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_504_100

Stock prices are negatively correlated with recessions. Below, you can see a chart showing the prices and volatility of the general stock market. The grey bars are recessions, so it is easy to see their impact on the stock market. The S&P 500 is a general index of the overall stock market. It was created and is maintained by the financial company Standard and Poors, which is a major credit rating company. The index consists of the prices of 500 stocks out of the 3,700 public companies listed on American stock exchanges, and the composition of these 500 selected companies reflects the composition of the entire market.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Adding bonds tends to lower both risk and potential return. The following chart shows the maximum gains and losses on various portfolios consisting of all stocks (on the left) through a series of mixed stocks and bonds to a portfolio consisting of all bonds (on the right). As you can see the maximum gains and losses are greatest with an all stock portfolio.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_514_100

Finally, some investment advisors suggest you should hold up to 10% cash in your portfolio, either for emergencies or to take advantage of bargains that may arise in the market. This should not be kept in a checking account but in a money market fund. The current annual return on money market funds is 1.7% (Vanguard Prime Money Market Fund).

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_516_100

Inflation can have a large impact on your investment, so it is important to understand how that works. Let’s say you have cash and save it by hiding it in your mattress. Your money gets less valuable every day by exactly the rate of inflation because money is something we need to buy goods and services. If you hide your savings in a mattress and the rate of inflation is 2%, your money is depreciating in value by 2% per year. The same thing happens to money you keep in a checking account that pays no interest. Your money is depreciating at a rate of 2% per year. Even further, the money you receive as a dividend or interest on your investment is also depreciating at the annual rate of inflation. The real quest, then, is to find an investment that gives a return greater than the rate of inflation.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_517_100

In order to be able to compare the return on all sorts of different investments, like buying stocks or buying a Picasso, we use the same measure to calculate returns. The return on an investment comes from two areas: dividends or interest paid and the price appreciation. For example, you may put your savings in stocks and get a dividend of 2% per year plus the stock price may have increased by 8% over the course of a year. Thus, your total return for that year would be 2% + 8% = 10%. Alternatively, those investors who buy gold or a Picasso do not get any interest or dividends but receive returns from the price appreciation of their asset over time. If you bought gold today at $1,600.00 per ounce and after a year its price was $1,700.00 per ounce, your annual return would be:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_521_100

The general calculation of a return on investment (ROI) is the appreciation in the price (value) of the investment (asset) over a year plus any dividends or interest earned during that year, compared to the original cost of the investment (asset). The calculation is thus:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_525_100

This calculation will yield a decimal which is then expressed as a percent annual return. The general formula is expressed as a backward-looking calculation:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_533_100

Now, here’s an example. Let’s say you purchase 100 shares of Apple stock at $5.00 per share. At the end of one year, it is now selling on the stock market for $6.00 per share. In addition, you receive a dividend of $1.00 from Apple during the year. Your return could be expressed like this:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_541_100

If your investment is held for multiple years, you would use the total price appreciation of the asset plus add up all the dividends and calculate your total return. You would then divide the total return by the number of years you held the asset to get the average annual return. This annual return allows investors to compare the annual returns for all sorts of investments that are dissimilar, such as paintings, antique automobiles, collectibles, and stocks and bonds.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_542_100

However, there is one more complication to consider: taxes on your profits from investments. The profits you make from the price appreciation of an asset is called a capital gain, and it is taxed when you sell the asset to realize the gain. Taxation of the capital gain is different if you own the asset for less than one year (a short-term capital gain) or own it for more than one year (a long-term capital gain). A short-term capital gain is just added to your regular income on your tax return and taxed at your regular income tax rate. On the other hand, if you sell the asset after owning it for more than one year, you will be taxed at the long-term capital gains rate. If your total taxable income is $39,375 or below, a single person will pay 0% capital gains tax. If their income is $39,376 to $434,550, they will pay a 15% capital gains tax.  Above that level, the rate jumps to 20%. The tax rates (or brackets) are somewhat different for married people. Tax laws give an incentive to hold investments over one year.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_544_100

Vanguard Mutual Funds, a not-for-profit, has created historical returns of various portfolios that are made up of different mixes of stocks and bonds going all the way back to 1926. Below are the returns of those different allocations.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_546_100

An income-oriented investor seeks current income with minimal risk to principal and is comfortable with only modest long-term growth of principal. They have a short-to mid-range investment time horizon.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_551_100

A balanced-oriented investor seeks to reduce potential volatility by including income-generating investments in their portfolio and accepting moderate growth of principal and is willing to tolerate short-term price fluctuations. They have a mid- to long-range investment time horizon.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_556_100

A growth-oriented investor seeks to maximize the long-term potential for growth of principal and is willing to tolerate potentially large short-term price fluctuations. They have a long-term investment time horizon. Generating current income is not a primary goal.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_561_100

We can actually trace the historical returns on stocks and bonds going all the way back to 1870. The historical returns do not, of course, guarantee that the same returns will happen in the future, but most of the stock market investors are wise, and wise investors demand certain minimum returns in order to take the risk on investments.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

s_562_100

In their 2019 study of investment returns, The Rate of Return on Everything, 1870–2015, Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M Taylor calculated returns on stocks, bonds, and housing in 16 developed nations going all the way back to 1870. As Thomas Picketty notes in his book Capital in the Twenty-First Century, housing is important in all developed nations, since it represents approximately one-half of the wealth in a typical economy (2021). Here is a graph of the real rates of return in the world:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Asset allocation is spreading out your investment in various financial assets to maximize your profit while minimizing your risk. However, as I stated before, in order to achieve a higher return, you must take a higher risk. A low risk portfolio would be invested in all bonds, and from 1926 to 2018 achieved an average annual return of 5.3% with low volatility. A moderately high risk portfolio would be invested in all stocks, and from 1926 to 2018 achieved an average annual return of 10.1% with much higher volatility.

Economics for Life: Real World Financial Literacy

Donald Wargo

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Professional stock pickers are merely making educated guesses as to which stocks will appreciate the most over the next year. This is because no one can accurately predict the future. Wall Street is myopic in their focus on short-term returns. In contrast, Warren Buffet, Chair of Berkshire Hathaway, has always focused on long-term profits.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Even with all their computer models and data dumps, not a single active stock picker has consistently beaten the overall rise or fall of the market, as measured by the stock market indexes of the Dow Jones Industrial Average, the S&P 500, or the Nasdaq. Therefore, the only way to achieve consistent average returns is to invest in a broadly diversified portfolio of investments. As mentioned before, a portfolio of 100% stocks has achieved a 10.1% average return over the 90+ years from 1926 to 2018.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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As a small investor, you will not have enough money to diversify by buying stocks yourself. Experts say you should have a minimum of 20 diverse stocks in a portfolio. Instead, you should invest in a mutual fund that contains all S&P 500 stocks. Almost every mutual fund company has a fund that is exactly that. Currently, you do not need to invest in bonds due to their lower returns. However, when you get within five years of retirement, you will need to rethink that strategy.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Finally, in your portfolio allocation, you do not need to invest in a global stock portfolio. This strategy was popular over fifteen years ago because when the U.S. was in a recession, Europe was not in a recession. This is no longer true. Globalization has connected world economies, and now European and U.S. Economies are procyclical. Another reason you do not need to invest in a global stock portfolio is that a portfolio of European stocks have consistently underperformed the S&P 500 by about 1% annually. Europe does not have the high-flying tech stocks like Apple or Google that are included in an S&P 500 mutual fund. In any case, most of the largest European companies like Nestle, BMW, or Mercedes are also listed on the U.S. stock exchanges.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Money market mutual funds are alternatives to savings accounts or certificates of deposit in banks or credit unions. Their annual returns are higher than bank and credit union savings accounts, but your funds do not have the government guarantee of the FDIC or CUIC. Money market mutual funds invest your money in bonds, and these returns fluctuate with the market. Vanguard Mutual Funds reports that the ten-year average annual return on its money market fund was .42%. Unless you want to park your money and not really invest it, you do not need to put your investment dollars in a money market fund.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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You can find quotes on bond yields and prices in The Wall Street Journal or on FIRNA’s Market Data Center. A bond is basically an I.O.U. or promissory note. A government or a company issues bonds in order to borrow money directly from investors. This is cheaper than borrowing from a bank because the bank adds overhead and profit to its loans. A bond is a promise to pay interest to the investor every year and then to pay back the investor at the end of a specified time period. A bond’s time period is also known as its length, term, or maturity. For example, the U.S. Government issues Treasury Bonds in order to finance the ongoing annual deficit. Currently, a newly issued 10-year Treasury Bond would likely have the following characteristics:

Economics for Life: Real World Financial Literacy

Donald Wargo

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When you buy a mutual fund, you are pooling your money along with other investors. You put money into a mutual fund by buying units or shares of the fund. As more people invest, the fund issues new units or shares. The investments in a mutual fund are managed by a portfolio manager. All mutual funds have a stated goal for the assets they invest in and a philosophy for how they will invest. According to Statista, there were approximately 7,900 mutual funds in 2019, and they managed over $21 trillion (2020). There are many mutual fund management companies, and each company offers many different types of mutual funds; trying to make an informed choice can make you dizzy. There are four broad categories of mutual funds: those that invest in stocks (equity funds), bonds (fixed-income funds), short-term debt (money market funds) or both stocks and bonds (balanced or hybrid funds). There are also many mutual funds that invest in specific sectors, such as technology, real estate, gold, or the bank sector.

Economics for Life: Real World Financial Literacy

Donald Wargo

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It minimizes the risk of loss to your overall portfolio. (Risk is defined by the standard deviation of the returns of your portfolio).

Economics for Life: Real World Financial Literacy

Donald Wargo

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The money you put in a retirement fund is tax-free, so it reduces your tax burden. You only pay taxes on it when you withdraw it at retirement (although you can also withdraw it early for certain hardships).

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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The earlier you contribute to your retirement plan, even if it is a small amount, the richer you will be at retirement due to the magic of compound interest.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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The business cycle is the term we give for the expansion and contraction of an economy. This is measured through Gross Domestic Product (GDP). GDP is the output and sale of goods and services in any economy measured over a period of time (usually one year). Traditionally, GDP is aggregated into four broad categories, as measured by the Bureau of Economic Analysis of the U.S. Commerce Department. These categories are represented in the following equation:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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The largest component of GDP is Consumption Expenditure. How comfortable consumers are opening their wallets every month has an outsized effect on the GDP and the business cycle. Here is the relative value of the components of GDP for 2020 (estimated, as of June 2020) in current dollars:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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The business cycle can be visualized as a graph of the value of GDP over time. Its fluctuations from its trend line are the expansions and recessions of the economy. I show a close-up of the period from 2000 to 2016 so you can see more clearly the fluctuations in actual GDP from the trend line. The graph also includes the last two recessions, March 2001 to November 2001, and December 2007 to June 2009.

Economics for Life: Real World Financial Literacy

Donald Wargo

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The blue is the trend line of GDP growing and the red is the actual real GDP. The deviation in the actual from the trend is the business cycle. The gray bars show the time of official recessions.  Note that GDP is below the trend during recessions, meaning GDP has decreased. Recessions have both a popular definition and an official definition. The popular definition is a drop in economic activity (a drop in GDP) for two successive calendar quarters (six months). On the other hand, the National Bureau of Economic Research (NBER), a group of academic economists from around the U.S., is the official arbiter of when we are in a recession and when a recession is over. The NBER defines a recession as follows:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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A recession is a significant decline in economic activity spread across the economy, normally visible in production, employment, and other indicators. A recession begins when the economy reaches a peak of economic activity and ends when the economy reaches its trough. Between trough and peak, the economy is in an expansion.

Economics for Life: Real World Financial Literacy

Donald Wargo

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There have been several business cycles in the economic history of the United States. Here is a graph of GDP and recessions (in gray bars):

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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The graph covers 1940 to 2020, so the drops in GDP during recessions may look small. However, note that in the Great Recession, GDP dropped 4.1% and 8,500,000 employees lost their jobs.  One the last line in the chart above, it states that since the end of WWII there have been 12 business cycles (recessions and expansions) including the Pandemic Recession. On average, recessions have lasted on average 11.1 months, while economic expansions have lasted on average 64.5 months (a little over five years).

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Does this mean that we can predict recessions? If that were possible, we could all become millionaires. As you will see from the graph below, the stock market (the S&P 500 Index) drops 6 months to one year before a recession and begins trending upward again 6 months or less prior to the end of the recession. That means if we could predict a recession, we could predict the stock market.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Unfortunately, the time between recessions and, to a lesser extent, the length of recessions is too variable to be able to accurately predict them. At an economic conference, I was able to ask Robert Hall, Chair of the National Bureau of Economic Research Committee on Business Cycles and professor at Stanford University, whether anyone can predict recessions. Dr. Hall said no one can predict recessions accurately. There are several characteristics of the business cycle that may not be immediately apparent from the graphs and charts above but are important to understand. Dr. Daron Acemoglu of MIT states these:

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Many aggregate macroeconomic variables move together in the business cycle. In the NBER’s definition of a recession, they lay out the most important economic variables they use to determine the business cycle: “…real GDP, real income, employment, industrial production, and wholesale-retail sales” (NBER.org).

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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It is very hard, if not impossible, to predict the turning points in the business cycle. As I mentioned earlier, Dr. Hall said it is impossible to predict recessions. It is equally impossible to predict the turning point of a recession, when the economic expansion begins.

Economics for Life: Real World Financial Literacy

Donald Wargo

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There is a persistence to the rate of economic growth. If the economy is growing in one quarter, it will likely grow in the next quarter as well. Contrariwise, if the economy is in a recession in one quarter, it is likely to decline again in the following quarter (Acemoglu, Laibson, & List, 2018).

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Baglini, N., & Nelson, K. (2010). Dopamine, Expected Utility and Decision Making in the Firm. In 1002132964 772838195 A. A. Stanton (Ed.), Neuroeconomics and the Firm. Cheltenham, UK: Edward Elgar.

Economics for Life: Real World Financial Literacy

Donald Wargo

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Baker, K., & Rabouin, D. (2020, June 09). Sports bettors may be a driving force behind the stock market surge. Retrieved from https://www.axios.com/sports-betting-stock-market-surge-0e945773-d676-4f0a-a6a0-a0f92611b10b.html

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Banerji, G. (2020, September 15). Why Did Stock Markets Rebound From Covid in Record Time? Here Are Five Reasons. Retrieved from https://www.wsj.com/articles/why-did-stock-markets-rebound-from-covid-in-record-time-here-are-five-reasons-11600182704

Economics for Life: Real World Financial Literacy

Donald Wargo

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Bauerlein, V. (2019, July 01). American Suburbs Swell Again as a New Generation Escapes the City. Retrieved from https://www.wsj.com/articles/american-suburbs-swell-again-as-a-new-generation-escapes-the-city-11561992889

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Bennett-Alexander, D. (2018). Employment discrimination. In R. Kolb (Ed.), The SAGE encyclopedia of business ethics and society (Vol. 1, pp. 1111-1115). SAGE Publications, Inc., doi:10.4135/9781483381503.n38

Economics for Life: Real World Financial Literacy

Donald Wargo

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Bernanke, Ben (2012), “Economic Measurement,” Remarks by Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System via Prerecorded Video to the 32nd General Conference of the International Association for Research in Income and Wealth Cambridge, Massachusetts, August 6, 2012.

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Bernanke, Ben (2010), “Commencement Address: The Economics of Happiness,” Remarks by Ben S. Bernanke Chairman Board of Governors of the Federal Reserve System at the University of South Carolina Columbia, South Carolina

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Bernard, P., Ellingrud, K., Godsall, J., Kotanko, B., & Reich, A. (2020, September 29). The future of life insurance: Reimagining the industry for the decade ahead. Retrieved from https://www.mckinsey.com/industries/financial-services/our-insights/the-future-of-life-insurance-reimagining-the-industry-for-the-decade-ahead

Economics for Life: Real World Financial Literacy

Donald Wargo

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Bernard, T. (2010, December 31). Why a Budget Is Like a Diet – Ineffective. Retrieved October 20, 2020, from https://www.nytimes.com/2011/01/02/weekinreview/02siegelbernard.html

Economics for Life: Real World Financial Literacy

Donald Wargo

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Business Cycle Dating Committee Announcement June 8, 2020. (2020, June 08). Retrieved from https://www.nber.org/news/business-cycle-dating-committee-announcement-june-8-2020

Economics for Life: Real World Financial Literacy

Donald Wargo

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Carpenter, J. (2019, September 13). Your Parents’ Financial Advice Is (Kind Of) Wrong. Retrieved from https://www.wsj.com/articles/your-parents-financial-advice-is-kind-of-wrong-11568367000

Economics for Life: Real World Financial Literacy

Donald Wargo

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Cassidy, J. (2020, September 17). How Boeing and the F.A.A. Created the 737 MAX Catastrophe. Retrieved from https://www.newyorker.com/news/our-columnists/how-boeing-and-the-faa-created-the-737-max-catastrophe

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Cheng, J., Wessel, D., & Younger, J. (2020, May 01). How did COVID-19 disrupt the market for U.S. Treasury debt? Retrieved from https://www.brookings.edu/blog/up-front/2020/05/01/how-did-covid-19-disrupt-the-market-for-u-s-treasury-debt/

Economics for Life: Real World Financial Literacy

Donald Wargo

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Chung, J. (2019, October 28). Hedge Fund Kings Face a Reckoning. Retrieved from https://www.wsj.com/articles/twilight-of-the-stock-pickers-hedge-fund-kings-face-a-reckoning-11572197217

Economics for Life: Real World Financial Literacy

Donald Wargo

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College Board (2020). College Access, Affordability, and Outcomes. Retrieved from https://research.collegeboard.org/reports/college-access

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy

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Correll, S. J., Benard, S., & Paik, I. (2007). Getting a Job: Is There a Motherhood Penalty? American Journal of Sociology, 112(5), 1297–1338. doi:10.1086/511799

Economics for Life: Real World Financial Literacy

Donald Wargo

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Davidson, K. (2020, August 03). U.S. Will Borrow Estimated $2 Trillion in Second Half of 2020, Treasury Says. Retrieved from https://www.wsj.com/articles/u-s-will-borrow-estimated-2-trillion-in-second-half-of-2020-treasurysays-11596482647

Economics for Life: Real World Financial Literacy

Donald Wargo

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De Linde Leonard, M., & Stanley, T. D. (2020). The Wages of Mothers’ Labor: A Meta-Regression Analysis. Journal of Marriage and Family, 82(5), 1534-1552. doi:10.1111/jomf.12693

Economics for Life: Real World Financial Literacy

Donald Wargo

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DeSilver, D. (2018, August 07). For most U.S. workers, real wages have barely budged in decades. Retrieved from https://www.pewresearch.org/fact-tank/2018/08/07/for-most-us-workers-real-wages-have-barely-budged-for-decades/

Economics for Life: Real World Financial Literacy

Donald Wargo

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Despite Lower Rates, More Than 650,000 Defaulted on Federal Student Loans. (2019, August 02). Retrieved from https://ticas.org/affordability-2/despite-lower-rates-more-650000-defaulted-federal-student-loans-0/

Economics for Life: Real World Financial Literacy

Donald Wargo

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Dunbar, R. I. (2004). Gossip in Evolutionary Perspective. Review of General Psychology, 8(2), 100-110. doi:10.1037/1089-2680.8.2.100

Economics for Life: Real World Financial Literacy

Donald Wargo

https://open.umn.edu/opentextbooks/textbooks/economics-for-life-real-world-financial-literacy