|MONEY and BANKING||LOW GRAPHICS|
Suppose you have just won 1 million dollars and want to invest it. You are considering saving account deposit, CD's, government bonds, mutual funds, stock market and investments into various business projects. How would you decide?
| Student 1 |
The first thing to consider when searching for options to invest your money is how you can achieve the maximum utility. To find the return on investments, one looks to calculate the NPV (net present value). This is the present value of all your investments and their future returns. NPV is calculated by taking the future value over the interest rate and time to maturity of your investment. In one period, NPV can be written as
In more than one period, however, the NPV is the sum of all the payments, so
If compounding interest rates are also a factor, then
where k is the frequency of compounding. In the case of compounding interest, one can see that the higher the frequency, the less impact the compounding may have, and its rate of change eventually begins to level off. It is important to note that any increase in interest rates decrease the NPV of an investment. Risk is also a large factor when deciding where to invest your money. The higher the risk a project has, the higher the return is likely to be. Investments such as government bonds and CD’s have a much smaller return on average than, say, the stock market. A benefit, however is that the risk is very low. If a person is very risk averse, then they would choose to invest in low risk projects such as bonds and savings deposits. If the person is interested in a higher return, and risk isn’t an important factor when making an investment, then the stock market is a likely choice for their investment. One concept I believe is very important to consider when investing is diversification. By increasing the number of projects (stocks, options, bonds…) in your portfolio, one can minimize their risk (variance) and also maintain a sufficient level of return. It is also important to consider the correlation of each project in your portfolio. If the different project have the highly positive correlation, a portfolio would not make sense. On the other hand, if your projects are negatively correlated, you can still obtain a return through diversification. If a person values diversification, then they would choose to put their money in mutual funds and invest in various business projects. The ultimate decision of where to invest your money is a combination of return on investment, sensitivity to risk, and individual preferences.
| Student 2 |
In order to decide between these 6 options, one has to consider his/her risk/return preferences and time horizon. All of these options have different risks and benefits attributed to them. Described in order of safety:
1. Government Bonds – Since this is the less riskiest investment, it offers a below average return, but virtually no risk of default. This option is sometimes preferred by elderly people with a short time horizon.
2. Saving Account – Again, this is a comparatively safe investment, but it depends on the commercial institution you trust your money to. Your deposits are only protected up to $100,000 by the FDIC; so, in case of a bankruptcy there is a chance of losing a significant portion of the investment. These usually offer a low return as well.
3. CD’s – this is relatively safe option with rate of return depending on the institution. Basically you loan the money to the bank and the longer the higher is the return. There are two major risks associated with this type of investment. First, you can tie your money for a long time without being able to manipulate it. Second, if you decide to invest long term, inflation could eat a lot of interest you make on it.
4. Mutual Funds – Depending on the type of fund, this investment can be very risky and very profitable, or relatively safe with an average return. If you decide to invest in a sector fund, which specializes on one sector of the economy and that sector happens to be hot at the time, the return could be very high. Also there are different yield funds which buy stocks of different companies according to their risk/return objectives.
5. Stock Market – Again, if a person is able to create a well-diversified portfolio, then it would be possible to eliminate most of the unsystematic risk present in the market. By applying his/her risk/return preferences to the efficient frontier constructed using his/her mix of securities, it is possible to find the optimal mix for the investor.
6. Business Projects – To evaluate a business project, investor, first of all, has to calculate the Net Present Value of the cash flows generated by the project. Everything above zero is satisfactory. Then an ROI figure would have to be calculated to see whether it complies with investor’s preference.
| Student 3|
In terms of making a sound investment, one must consider many factors and must pick a method of investing that corresponds most closely with one's preferences. As always, something that presents value comes with an inherent risk. One must decide what type of risk one is willing to assume. Financial innovations during the twentieth century have provided just about every instrument of investment that completely satisfies the market demand for investment. With a million dollars, I would have the opportunity to engage in just about any project of investment that I desire and would like to receive a substantial reward, while not risking my entire winnings. If I wanted a very safe investment that only paid minimal interest, I could consider savings accounts and government bonds. Since the Federal deposit commission (FDIC) would support up to $100,000 in deposits, I could place this much in various banks and have nearly zero risk. I would have the added benefit of liquidity and therefore could take the money out when I need it. However, this savings account probably would not be a very profitable investment since most savings accounts pay less than 3% interest annually. Government bonds are another risk-averse type investment where I could chose a term to maturity that is in line with my preferences. A long-term bond will pay a higher interest rate, but only provides liquidity if I sell it on an exchange. Although bonds like this are usually very free of risk in the United States, interest-rate risk could pose unnecessary risks. During a time of recession, if the Fed were to increase interest rates enough in an attempt to spur investment, excess capital losses could turn into a poor investment. In addition I could choose between tax free municipal bonds, Treasury bills, or US government bonds. Each carries its own terms and provides some minimal amount of risk, but each also caters to various preferences. If I wanted to put my money in a CD (certificate of deposit), I would be assuming substantially more risk. This is because the CDs are contracts for a specific length of time and early withdrawal of funds has substantial penalties. Those CDs are bank deposits and therefore carry little default-risk. As almost all securities do, it does possess some interest rate risk. A recent financial innovation of negotiable CDs can eliminate the penalty of early withdrawal, but its returns are reduced. Another financial innovation allows people with even small quantities of money to make diversified investments. Mutual funds gather large sums of money from people and them invest on their behalf. If the expertise of the managers is high, the benefits can be enormous, but the risks assumed are inherent. Since I have $1 million I could also invest in a hedge fund. This is a mutual fund, but requires a longer-term investment and an extremely large amount of capital. While historically it assumed little risk, Long Term Capital, a hedge fund demonstrated that the risks are not only present, but are quite large. Stock market investing implies a lot of risk. I would use lots of research in order to make sound investments, but must make sure to diversify. If I wanted the possibility of large returns with a corresponding risk of losing everything, this is the market for me. In terms of investing with business projects, I would need to consider the NPV of the project. First of all, it must exceed zero and must have a smaller amount of risk. Since investments in individual projects bring asymmetric information, I would be careful. In general when deciding what to invest in, one must consider risk, expected returns, liquidity, and various perks. Then I would make a decision, weighing the relative benefits versus the costs involved with the investment.
When making any investment decision, an investor must first consider an objective in mind, such as an expected rate of return the investor would like to earn over a given time horizon. The investor’s willingness to take on risk, or lack of risk tolerance, will also be an important decision in determining what investment vehicles to use. As a 21-year-old and the stock market being at a relatively low level now as compared to the past few years, I would invest a large portion, at least 70%, into stocks and mutual funds. These investment vehicles are more risky than government bonds and bank CD’s, but I have a higher risk tolerance because of my young age and lack of financial liabilities, such as mortgages, car insurance, etc. Of my investments into mutual funds, I would buy equity funds, bond funds, and growth & income funds (a mix of stocks and bonds) to diversify my risk. I would also invest in exchange traded funds, such as Spiders that mirror the S&P500 index, for greater risk diversification. Of the remaining 30%, 25% would be invested in CD’s and government bonds. Within the next several decades, I will be obligated to make fixed payments such as rent or mortgage payments. I want to make sure that I will have sufficient funds to accomplish this. By holding government bonds until maturity and CD’s, I can avoid paying transaction costs, such as brokerage commissions, allowing me to use the full value of my holdings to meet my fixed payment obligations. By holding government bonds until maturity, I also avoid interest rate risk. I would put the remaining 5% into a savings account as a safety net until I start working full-time after graduation. None of my funds would be invested in various business products for two primary reasons. First of all, I feel that even a total of $1 million is insufficient to be a venture capitalist. Secondly, for me to even consider investing in any business project, the project must have very high internal rate of return, which is the rate of return that sets the present value of the project's cash flows equal to the initial costs of the project. (Zvi Bodie: Essentials of Investments; 4. edition, McGraw-Hill/IRWIN; New York, 2001). A high IRR would be needed because I would demand a high rate of return to compensate for my risk undertaking. With asymmetric information issues, such as moral hazard and adverse selection, These risks would outweigh any expected return payoff possible and would therefore deter me from investing in various business projects.
| Student 5 |
Wow! A million dollars! If I won a million dollars I would probably spend many hours in the BU Pub studying Mishkin’s books, The Wall Street Journal, and portfolio theory. The one choice I know I would not make is to put any money in a savings account, the interest rate is too low and I would be willing to take more risks than this. In today’s economy I would prefer to probably buy a few things. I would purchase municipal bonds, options, mutual funds, and invest in business projects that involve the purchase of land. I would also invest heavily in real estate b/c of the current low interest rate. It is interesting to not that I would invest n both real estate and some bonds, because usually when interest rates are low bond prices are high and may not make a good investment, the reason for this is to attempt to hedge risk and will be discussed further later. Decisions on which way to invest and were to put the majority of my money would be based on a few major key points: my aversion to risk, my expectation of the future sate of the economy, my knowledge of the present state of the economy, and my need for liquid assets (i.e. when I will want the money to be able to spend it). Underlying almost all investments, is the idea that with increased risk come the possibility of increased return. Back in the days of “day trading” in the late 1990’s people would, in a sense, gamble with their money on stocks they knew little about. At the end of the day they owned nothing and either walked away with a loss or profit; much like someone who walks out of Las Vegas after gambling. Although “day trading” basically does not exist anymore some still see the stock market as gambling with high risk. The key is to place money in investments that offer the highest rate of return with the least amount of risk (underlying principle of portfolio theory). From the above choices I would spread out my money in many different investments, diversifying and thus decreasing risk and varying return. Specific examples of this will be shown later. (Note: the above paragraphs represent a basic sketch of where to put money and the general theory that underlies all investment. The following will represent specifically where I would invest my money, how, and why.) I would purchase municipal bonds because they offer a reasonable return and since they are backed by the government, they are not a risky investment (I am risk adverse). I would purchase these bonds in a specific way: with a credit card! This may seem counter intuitive, why would I purchase bonds with a credit card if I did not need the credit, I just won a million dollars? I would do this to ‘juice’ the returns. Almost all credit cards offer some type of point system in which you get points (1 point = 1 dollar spent or an equivalent in “sky miles”). By purchase the bonds with a credit card I would be making a long term investment, but I would still be seeing immediate gains, further since I had the money to pay for the bonds when the bill came I would not have to worry about the debt associated with a credit card, thus I would be ‘juicing the bond’ (idea taken from The Wall Street Journal, Wends Oct. 2nd, 2002). I would purchase mutual funds based on portfolio theory, because I would not be buying a large number of these shares, and thus would be getting the most for my money. I would be buying such a small portion of the companies stock, that instead of buying the stock outright, I would invest in mutual funds. This would allow me to own a diversified portfolio (diversify risk and return) without a lot of money. Also I would make sure it was a money market mutual fund so that I could write checks against it, in the event I needed the money in the short run, because most of my other assets would be tied up in relatively non-liquid assets. I would also buy options (my new favorite thing I have learned about in economics). Options which give investors the right to buy or sell stocks at a certain price by a specific date are a great way to make money in the current unstable economy. I would specifically use covered-call options. The way it works is I would sell contracts that give other investors the right to purchase my shares at a set price, and in return would be paid a premium on the calls. If the stock goes down (in the current market I would suspect it would), and I would keep the payment. If the stock goes up then I make less profit on the stock than if I had not have sold the call. Covered call options are so appealing because “you’re basically owning a stock and generating a return that can be greater than bond yields, says Steven Silverman, senior vice president at Connors Investor Services” (TWSJ, Tues. Oct. 8th, 2002). If covered call options seem to good to be true, well you know what they say; there is a downside to covered calls. If the option is exercised you are forced to sell the shares (thus taking a tax hit). Also if the stock you sell the option to jumps way up, you take a huge profit loss. The problem with covered calls as described by Ross Levin is “you take away your upside and you don’t protect your downside” (TWSJ, Tues. Oct. 8th, 2002). I still personally like the idea of covered calls and options in general. (Note: this detailed analysis of options was done because it is a particularly interesting/confusing section of Mishkin’s text). I would by real estate, particularly apartments or a three family house, for two reasons: 1) to have liquid assets coming in 2) to build equity. By owning a three family house I could live in one of the apartments and rent the other two, thus receive a rent check every month and having liquid assets which were not tied up in the apartment itself. Every month I paid the mortgage, I would be building equity, nothing hard to understand here, building equity is always a good thing, especially when the cash flow does not have to change.
| Student 6 |
After winning 1 million dollars I would need to make smart financial decisions. Between saving account deposits, CD’s, government bonds, mutual funds, stock market, and business project investments, how do I handle my money most efficiently? Well first, I would hire myself a financial advisor to supply me with all the information, pros and cons, interest rates, opportunities, risk, and other factors influencing my economic decision. A saving account deposit would store my money and at the same time I would earn interest payments. But whether or not the interest rate is up or down will affect how much money I earn. However, there is less risk in putting my money into a savings account, so it depends on whether I’m a “risk-lover” or not. A certificate of deposit (CD) is a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price. CD's are an extremely important source of funds since after 1961, when they became more liquid and more attractive for investors. The Us Government Bond market is ready to buy and sell securities to anyone who comes willing to accept their prices and it is very competitive. Mutual funds allow shareholders to hold more diversified portfolios by pooling their resources so that they can take advantage of lower transaction costs when buying large blocks of stocks and bonds. However investment in mutual funds can be risky. The stock market and business project investments are much riskier because it’s impossible to predict the future and what will happen. Also, with asymmetric information resulting in adverse selection, and moral hazard, the stock market proposes unfair disadvantages. But my financial advisor will supply me with enough information, and government regulation will hopefully keep the market running smoothly, so I will definitely invest some money into the stock market. Business investments are also risky, but could be very profitable. I have to decide whether I want to be a debt holder or an equity holder. There are advantages and disadvantages to both. An equity holder claims a part in a company’s net income. They are paid regularly, but they are residual claimants, which means that a company must pay its debt holders before its equity holders. A debt holder receives a fixed amount of money until a specific maturity date. If a company suddenly makes a huge profit, debt holders do not benefit because their payments are fixed. Risk, liquidity, expected returns are all other factors involved in the decision of financing money. There is so much information to know before taking one million dollars and putting it somewhere. If I really won that kind of money, I would put most of it in savings, and the rest invest in the stock market and business projects.
| Student 7 |
If I won $1 million dollars and wanted to invest it, I would consider three main things: 1) the risk involved in the investment, 2) the average rate of return I would get from each option, and 3) the time period of the investment and its level of liquidity.
First of all, these investment options all have different levels of risk. Savings accounts, CDs, and government bond have little to no risk. (In the US this is usually true, however the risk will depend on the stability of the banking system and on the government in a country.) The stock market has a high level of risk because your earning money depends on the success of the country, which is usually hard to anticipate. Mutual funds are a bit less risky than stocks because they include bonds (which are less risky than stocks in most cases) and they are made of a diverse portfolio. If one company within the portfolio does badly, another might do well, offsetting the risk. ADDITIONALLY, IF THE MUTUAL FUND IS AN OPEN-ENDED FUND AS MOST ARE, THE SHARES CAN BE REDEEMED AT ANY TIME AT A PRICE THAT CORRESPONDS TO THE FUND’S VALUE. THIS CHARACTERISTIC OBVIOUSLY MAKES THE MUTUAL FUND LESS RISKY SINCE THE OWNER CAN GET RID OF HIS SHARES WHENEVER HE WANTS. Investments into various business projects will have a high risk that obviously depends on the success of the business, but I think in most cases this would be a high risk (of course, if you have reason to be certain of a company’s success (INSIDER INFORMATION), the risk is less). In deciding what level of risk is right for you, you must decide if you are risk adverse or if you are a risk taker. Like myself, most people are risk adverse.
The next consideration is the average rate of return, which is usually POSITIVELY correlated with risk. This means that if risks are high, usually rates of return will be HIGH. THIS MAKES SENSE BECAUSE IN ORDER FOR SOMEONE TO BE WILLING TO TAKE ON A HIGH RISK INVESTMENT, THEY MUST BE ENTICED BY A HIGH RATE OF RETURN. Savings account deposits will offer the lowest return. CDs and government bonds also offer fairly low returns. Due to the risky nature of stocks and business projects, rates of returns could be very high or very low…the average rate of return will be in between. Lastly, mutual funds will usually have a higher average rate of return than savings accounts, CDs, or government bonds.
The last thing I would consider is the length of maturity and its liquidity. Savings accounts can be taken out at any time, AND THEREFORE, ARE RELATIVELY LIQUID. CDs must stay in for a short to medium period of time, SO THEY ARE LESS LIQUID. Government bonds can be 3 months, 6 months, 2 years, 10 years, etc. BY LOOKING AT THE YIELD CURVE (A CURVE THAT PLOTS THE YIELDS ON BONDS WITH DIFFERING TERMS TO MATURITY), YOU WILL SEE THAT BONDS OF 3 MONTHS USUALLY HAVE THE LOWEST INTEREST RATES AND THOSE OF SEVERAL YEARS USUALLY HAVE THE HIGHEST INTEREST RATES. Mutual funds will usually provide options of buying back your shares at any time AND THEREFORE ARE FAIRLY LIQUID. However, on the secondary market, stocks AND SOME TYPES OF MUTUAL FUNDS cannot be sold, unless you find a seller so they are very un-liquid. Various business projects can be medium/long-term (AND IN RARE CASES SHORT TERM), but they are usually not liquid SINCE THE MONEY MUST BE LENT OUT LONG ENOUGH FOR DEVELOPMENT OF THE BUSINESS PROJECT.
Conclusion: I would choose to invest in a short-term government bond. Because I do not have much money, I cannot afford a high-risk investment. Also, I would like it to be short-term since I will need the money soon to go to graduate school (THIS MEANS I WILL NEED AN INVESTMENT THAT WOULD BE LIQUID WITHIN A SHORT PERIOD OF TIME). Furthermore, since I am already worried about finding a job, school, etc., I do not need the added stress of a risky investment.
| Student 8|
The decision on how to invest $1 million is difficult, which is why there are so many financial institutions that charge a lot of money to make to this decision for you. However, there are certain elements on which the favorability of the investment decision depends upon. First of all, one must take into account a person’s individual characteristics, such as the age, risk preference and investment purpose. Furthermore, the overall state of the economy must be taken into account. Expected interest rate and inflation rate can all affect an investments performance. Finally, it is also important to examine the risk/return relationship between the investment possibilities in question. Other things equal, the investor should prefer higher return for a given level of risk (or lower risk for a given level of return). With diversified portfolios it is often possible to achieve one of the two instances above. A person’s age is important, both to establish risk preference and the aim or the investment. For example, a young person in her twenties and thirties is probably much more likely to take investment risks than a person close to retirement. Not only does the young person still have many worker years ahead, through which she can make up for losses, but she also has a longer period of time over which she can make up for losses, but she also has a longer period of time over which fluctuations can be smoothed out. A typical stock goes through periods of high and low value. A person close to retirement who is dependent on their stocks for their wealth or pension can be strongly affected by such fluctuations. With such a close time horizon, it makes more sense to be invested in less risky assets such as T-bills or bonds than to invest in stock, because the invested capital is not so likely to be affected by short-term fluctuations. An investor who is investing with a longer time horizon, for example for their child’s college education, may choose some combination of stocks and bonds. Finally, as mentioned above, for people in their twenties an all-stock portfolio would be recommendable.
Other things equal, the purpose of the investment will also contribute to narrowing down investment choices. If the purpose is to have a certain amount available to pay in the near future, then a CD may well be the choice of investment. These have the added advantage of being highly liquid – they can be sold immediately when cash is needed. The maturity of the investment may also be known beforehand (thus narrowing the scope of investment possibilities) because there may be a specified time when a liability will occur. For example, a liability to pay a bill in six months could be taken care of by investing the present value of the liability in a six month T-bill. The amount will grow to exactly the value of the liability in six months. Personal characteristics can also affect risk-preferences. An investor with a high risk tolerance would probably be likely to invest in more risky assets, such as stocks, regardless of age, investment purpose, and so on.
The state of the economy is also important. Expected interest rates and inflation rates can strongly affect stock and bond prices and consequently can affect the expected return on these investments. In times of high inflation it would be unwise to invest in a bond that pays a fixed rate of interest, because the inflation will substantially lower the real rate of return on the investment. By contrast, if the investor believes that future interest rates are expected to fall it would be wise to invest in a bond that pays a fixed (relatively) higher interest rate now.
The risk/return relationship can be analyzed with respect to mutual funds, stock markets and a potential investment in various business projects. Investing in a mutual fund, or stock market index as a whole, gives the investor the benefit of diversification and lowers transaction costs. Nevertheless, mutual funds must be evaluated on a risk-adjusted basis in order to determine which one’s do better.
In my case, if I were to invest $1 million I would most likely invest in a mutual fund. Given my lack of expertise in the financial markets it would be preferable for me to have someone set up a portfolio, thus reducing risk and transaction costs. Given my young age, the portfolio would probably contain a large number of stocks, which may have more potential profitability compared to more risk-free investments, such as government bonds.
Source: Mishkin, Frederic S. The economics of Money, Banking and Financial Markets
| Student 9 |
In terms of making a sound investment, one must consider many factors and must pick a method of investing that corresponds most closely with one's preferences. As always, something that presents value comes with an inherent risk. One must decide what type of risk one is willing to assume. Financial innovations during the twentieth century have provided just about every instrument of investment that completely satisfies the market demand for investment. With a million dollars, I would have the opportunity to engage in just about any project of investment that I desire and would like to receive a substantial reward, while not risking my entire winnings. If I wanted a very safe investment that only paid minimal interest, I could consider savings accounts and government bonds. Since the Federal deposit commission (FDIC) would support up to $100,000 in deposits, I could place this much in various banks and have nearly zero risk. I would have the added benefit of liquidity and therefore could take the money out when I need it. However, this savings account probably would not be a very profitable investment since most savings accounts pay less than 3% interest annually. Government bonds are another risk-averse type investment where I could chose a term to maturity that is in line with my preferences. A long-term bond will pay a higher interest rate, but only provides liquidity if I sell it on an exchange. Although bonds like this are usually very free of risk in the United States, interest-rate risk could pose unnecessary risks. During a time of recession, if the Fed were to increase interest rates enough in an attempt to spur investment, excess capital losses could turn into a poor investment. In addition I could choose between tax free municipal bonds, Treasury bills, or US government bonds. Each carries its own terms and provides some minimal amount of risk, but each also caters to various preferences. If I wanted to put my money in a CD (certificate of deposit), I would be assuming substantially more risk. This is because the CDs are contracts for a specific length of time and early withdrawal of funds has substantial penalties. Those CDs are bank deposits and therefore carry little default-risk. As almost all securities do, it does possess some interest rate risk. A recent financial innovation of negotiable CDs can eliminate the penalty of early withdrawal, but its returns are reduced. Another financial innovation allows people with even small quantities of money to make diversified investments. Mutual funds gather large sums of money from people and them invest on their behalf. If the expertise of the managers is high, the benefits can be enormous, but the risks assumed are inherent. Since I have $1 million I could also invest in a hedge fund. This is a mutual fund, but requires a longer-term investment and an extremely large amount of capital. While historically it assumed little risk, Long Term Capital, a hedge fund demonstrated that the risks are not only present, but are quite large. Stock market investing implies a lot of risk. I would use lots of research in order to make sound investments, but must make sure to diversify. If I wanted the possibility of large returns with a corresponding risk of losing everything, this is the market for me. In terms of investing with business projects, I would need to consider the NPV of the project. First of all, it must exceed zero and must have a smaller amount of risk. Since investments in individual projects bring asymmetric information, I would be careful. In general when deciding what to invest in, one must consider risk, expected returns, liquidity, and various perks. Then I would make a decision, weighing the relative benefits versus the costs involved with the investment
| Student 10 |
Investing in only one of the following saving account, CDs, government bonds, mutual funds, stock market or different investment projects would be a big mistake. As corporations personal portfolios have to be also diversified. Of course, if you have something around 10000 it hard to diversify your portfolio, but in the case of 1 mln. that's the only way to go. Most of the portfolios have a combination of different investments. For example even the interest rates on government bonds are low they are proven to be very safe investment, so the person should definitely think of having it in the portfolio. The market for CDs became very popular in the last decade (NOT LAST DECADE ACTUALLY A LITTLE BEFORE BECAUSE THEY WERE CREATED IN 1961), but it is mainly used by large corporations (BECAUSE THE ARE ISSUED IN 100000 DOLLARS OR OVER ), even though they don't have high interest rates it's also pretty safe investment. Saving account deposit with the option that you can always withdraw money in case of emergency would not be a bad idea. Mutual funds and stock market usually have higher interest rates of return but considered more riskier. Average return on stock market has been about 7%, which is much higher than 2-3% on gov. bonds and saving accounts. And in the end, of course, the investment into the projects usually bring pretty high returns, if successful. In their book "Investment Under Uncertainty" Pindick and Dixit (two economists) consider different types of investment projects and show the methods of hedging the risk(IT'S ANALOG OF OPTIONS). For example, you invest in the company which is going to produce widgets with price either phigh or plow if the price phigh you gain if plow your investment fails. You can choose to hedge your portfolio by entering contract that you'll sell widgets at some price p, so that on average your portfolio will be risk neutral. You can also make it risk-averse depending on your preferences. Hedging portfolios is important thing and can be used by entering future contracts, options etc. Thus, your decision should be made upon the best interest rates of different types of investments, which can be made less risky.
| Student 11 |
To decide between the various savings and investment opportunities, I would consider the current interest rates, historic returns, my investment time frame, my risk preference, the standard deviation of expected returns, liquidity, and give most weight to a calculation of expected future cash flows from the investments.
When examining interest rates, I would determine the current rates for savings accounts, CD’s, and bonds. I would also try to project future interest rates. By examining a 30-year Treasury bill, I could compare investment returns to the “risk free” rate of return on the T-bill.
To evaluate stock market and mutual funds, I would examine their historic returns versus the “risk free” rate to determine if the GENERALLY higher rate of return ON STOCKS AS COMPARED WITH SAVINGS ACCOUNTS, CD’S AND BONDS is enough to compensate for the increased risk. I would look at industry outlooks for various stocks and mutual funds and put together a securities portfolio BY MIXING VARIOUS INDUSTRIES AND SECTORS AND EXAMINING BETAS ON THE VARIOUS SECURITIES TO reduce risk by lowering the standard deviation of EXPECTED RETURNS.
I would likely be more willing to invest in the stock market if I had a large time frame before I would need to liquidate the position, since the markets are cyclical. ALTHOUGH THE DOW HAD A NET INCREASE OF MORE THAN 150% IN THE LAST TEN YEARS, IT DECLINED CLOSE TO 25% IN THE LAST TWO YEARS. THEREFORE, DUE TO VOLATILITY, STOCKS AND MUTUAL FUNDS WOULD BE BETTER SUITED FOR AN INVESTOR WITH A LONGER TIME HORIZON.
If I wanted high liquidity, I would be more apt to invest in savings accounts or stocks of companies with high trading volume and avoid long term investments like CD’s. IF I WERE TO INVEST IN VARIOUS PRIVATE BUSINESS PROJECTS, MY INVESTMENT WOULD BE VERY ILLIQUID AND DEPENDING ON THE TYPE OF CORPORATION OR BUSINESS, I COULD BE HELD FINANCIALLY ACCOUNTABLE FOR THE FIRM’S DEBTS BEYOND THE AMOUNT OF MY INVESTMENT.
After determining my preferences, I would determine my personal discount rate for each investment, WHICH WOULD BE BASED ON THE RISK-FREE RATE OF RETURN, PLUS A MATURITY PREMIUM, INFLATION PREMIUM, AND default RISK PREMIUM, AND DISCOUNT THE FUTURE EXPECTED CASH FLOWS TO THE PRESENT AND CHOOSE THE INVESTMENT STRATEGIES WITH THE HIGHEST NET PRESENT VALUES. I WOULD DIVERSIFY AMONG VARIOUS OPPORTUNITIES TO REDUCE RISK.
| Student 12|
Deciding how to invest a million dollars completely depends on the risk level one is willing to take in order to potentially gain high profits. In other words, how much is a person willing to expose his money to a potential loss. Someone who is afraid to subject his money to risk will invest in US treasury bonds, which have nearly no risk and yield a certain, small interest every specified time period. Personally, I would be more inclined to invest in something more risky but with higher potential returns. One option is the Stock Market. If investing in the market, I would be sure to diversify my investment and choose a portfolio that minimized my risk and maximized the potential profit. In order to do so, I would choose two or more companies with negative correlations approaching one so that my investment would have little volatility. Another possibility would of course be to invest in various business projects. Although in today’s market one million dollars will not allow you to undertake massive projects, it would potentially allow for exposure to some good ideas , even if you have to go in with only a percentage. In order to evaluate a potential business project, one must evaluate everything from products marketability, its viability, production cost, a company’s business record and maybe most importantly, evaluate a prospective business projects management. Bottom line, it becomes a question of whether the people you would be giving your money too can sell the product or service they describe. Although not an easy question, it is essential to all businesses investment. In today’s economy, having a good idea is simply not enough. Investment can also go toward things like Real Estate and can yield potentially high profits. Its all comes down to whether your estimation of the future market will in fact be correct. (1)
(1) Business heavily relies on knowing and examining ones market and coming to a sound conclusion based upon that evaluation. There is no perfect way to invest a million dollars, for if there was, we would all be extremely wealthy. However, modern business practices have allowed us to way our options properly. When John D. Rockefeller used vertical integration as a business practice in the rise of Standard Oil, it was based on a proper market evaluation rather then some gut instinct. He realized that if you purchase the entire line of production for a specific product, your potential profits are enormous. His success was his business foresight and in any investment, that’s the greatest tool an entrepreneur can possess. My million dollar investment would thus likely go into some unique product concept which I believe in and I see potential in. Whether it be on the stock market or some other market, it would be evaluated thoroughly so as to satisfy me that I am making a good decision. The outcome, regardless of what it was, would knowingly have been made on my best effort and would hopefully succeed.