17.3How to Accumulate Personal Wealth

Financial Investment Return Risk Liquidity Gold Medium High Low Collectibles Low to medium High Low TABLE 17.3Key Characteristics of Financial Investments The household investment choices listed here display a tradeoff between the expected return and the degree of risk involved. Bank accounts have very low risk and very low returns; bonds have higher risk but higher returns; and stocks are riskiest of all but have the potential for still higher returns. In effect, the higher average return compensates for the higher degree of risk. If risky assets like stocks did not also offer a higher average return, then few investors would want them. This tradeoff between return and risk complicates the task of any financial investor: Is it better to invest safely or to take a risk and go for the high return? Ultimately, choices about risk and return will be based on personal preferences. However, it is often useful to examine risk and return in the context of different time frames. The high returns of stock market investments refer to a high average return that we can expect over a period of several years or decades. The high risk of such investments refers to the fact that in shorter time frames, from months to a few years, the rate of return may fluctuate a great deal. Thus, a person near retirement age, who already owns a house, may prefer reduced risk and certainty about retirement income. For young workers, just starting to make a reasonably profitable living, it may make sense to put most of their savings for retirement in mutual funds. Mutual funds are able to take advantage of their buying and selling size and thereby reduce transaction costs for investors. Stocks are risky in the short term, to be sure, but when the worker can look forward to several decades during which stock market ups and downs can even out, stocks will typically pay a much higher return over that extended period than will bonds or bank accounts. Thus, one must consider tradeoffs between risk and return in the context of where the investor is in life.

17.3 How to Accumulate Personal Wealth

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Explain the random walk theory
• Calculate simple and compound interest
• Evaluate how capital markets transform financial capital

Getting rich may seem straightforward enough. Figure out what companies are going to grow and earn high profits in the future, or figure out what companies are going to become popular for everyone else to buy. Those companies are the ones that will pay high dividends or whose stock price will climb in the future. Then, buy stock in those companies. Presto! Multiply your money! Why is this path to riches not as easy as it sounds? This module first discusses the problems with picking stocks, and then discusses a more reliable but undeniably duller method of accumulating personal wealth.

Why It Is Hard to Get Rich Quick: The Random Walk Theory

The chief problem with attempting to buy stock in companies that will have higher prices in the future is that many other financial investors are trying to do the same thing. Thus, in attempting to get rich in the stock market, it is no help to identify a company that is going to earn high profits if many other investors have already reached the same conclusion, because the stock price will already be high, based on the expected high level of future profits. The idea that stock prices are based on expectations about the future has a powerful and unexpected implication. If expectations determine stock price, then shifts in expectations will determine shifts in the stock price. Thus, what matters for predicting whether the stock price of a company will do well is not whether the company will actually earn profits in the future. Instead, you must find a company that analysts widely believe at present to have poor prospects, but that will actually turn out to be a shining star. Brigades of stock market analysts and individual investors are carrying out such research 24 hours a day. The fundamental problem with predicting future stock winners is that, by definition, no one can predict the future news that alters expectations about profits. Because stock prices will shift in response to unpredictable future news, these prices will tend to follow what mathematicians call a “random walk with a trend.” The “random walk” part means that, on any given day, stock prices are just as likely to rise as to fall. “With a trend” means that over time, the upward steps tend to be larger than the downward steps, so stocks do gradually climb. If stocks follow a random walk, then not even financial professionals will be able to choose those that will beat the average consistently. While some investment advisers are better than average in any given year, and some even succeed for a number of years in a row, the majority of financial investors do not outguess the market. If we look back over time, it is typically true that half or two-thirds of the mutual funds that attempted to pick stocks which would rise more than the market average actually ended up performing worse than the market average. For the average investor who reads the newspaper business pages over a cup of coffee in the morning, the odds of doing better than full-time professionals is not very good at all. Trying to pick the stocks that will gain a great deal in the future is a risky and unlikely way to become rich.

Getting Rich the Slow, Boring Way

Many U.S. citizens can accumulate a large amount of wealth during their lifetimes, if they make two key choices. The first is to complete additional education and training. In 2020, the Bureau of Labor Statistics reported median weekly usual earnings for full-time wage and salary workers age 25 and over that corresponded to annual income of $40,612 for those with a high school diploma, $48,776 for those with a two- year associate degree, and $67,860 for those with a four-year bachelor’s degree. Learning is not only good for you, but it pays off financially, too. The second key choice is to start saving money early in life, and to give the power of compound interest a chance. Imagine that at age 25, you save $3,000 and place that money into an account that you do not touch. In the long run, it is not unreasonable to assume a 7% real annual rate of return (that is, 7% above the rate of inflation) on money invested in a well-diversified stock portfolio. After 40 years, using the formula for compound interest, the original $3,000 investment will have multiplied nearly fifteen fold: Having $45,000 does not make you a millionaire. Notice, however, that this tidy sum is the result of saving $3,000 exactly once. Saving that amount every year for several decades—or saving more as income rises—will multiply the total considerably. This type of wealth will not rival the riches of Microsoft CEO Bill Gates, but remember that only half of Americans have any money in mutual funds at all. Accumulating hundreds of thousands of dollars by retirement is a perfectly achievable goal for a well-educated person who starts saving early in life—and that amount of accumulated wealth will put you at or near the top 10% of all American households. The following Work It Out feature shows the difference between simple and compound interest, and the power of compound interest. WORK IT OUT Simple and Compound Interest Simple interest is an interest rate calculation only on the principal amount. Step 1. Learn the formula for simple interest: Step 2. Practice using the simple interest formula. Example 1: $100 Deposit at a simple interest rate of 5% held for one year is: Simple interest in this example is $5. Example 2: $100 Deposit at a simple interest rate of 5% held for three years is: Simple interest in this example is $15. Step 3. Calculate the total future amount using this formula: Step 4. Put the two simple interest formulas together. Step 5. Apply the simple interest formula to our three year example. Compound interest is an interest rate calculation on the principal plus the accumulated interest. Step 6. To find the compound interest, we determine the difference between the future value and the present value of the principal. This is accomplished as follows: Step 7. Apply this formula to our three-year scenario. Follow the calculations in Table 17.4 Year 1 Amount in Bank $100 Bank Interest Rate 5% Total $105 $100 + ($100 × 0.05) Year 2 Amount in Bank $105 Bank Interest Rate 5% Total $110.25 TABLE 17.4 $105 + ($105 × .05) Year 3 Amount in Bank $110.25 Bank Interest Rate 5% Total $115.75 $110.25 + ($110.25 × .05) Compound interest $115.76 – $100 = $15.76 TABLE 17.4 Step 8. Note that, after three years, the total is $115.76. Therefore the total compound interest is $15.76. This is $0.76 more than we obtained with simple interest. While this may not seem like much, keep in mind that we were only working with $100 and over a relatively short time period. Compound interest can make a huge difference with larger sums of money and over longer periods of time. Obtaining additional education and saving money early in life obviously will not make you rich overnight. Additional education typically means deferring earning income and living as a student for more years. Saving money often requires choices like driving an older or less expensive car, living in a smaller apartment or buying a smaller house, and making other day-to-day sacrifices. For most people, the tradeoffs for achieving substantial personal wealth will require effort, patience, and sacrifice.

How Capital Markets Transform Financial Flows

Financial capital markets have the power to repackage money as it moves from those who supply financial capital to those who demand it. Banks accept checking account deposits and turn them into long-term loans to companies. Individual firms sell shares of stock and issue bonds to raise capital. Firms make and sell an astonishing array of goods and services, but an investor can receive a return on the company’s decisions by buying stock in that company. Financial investors sell and resell stocks and bonds to one another. Venture capitalists and angel investors search for promising small companies. Mutual funds combine the stocks and bonds—and thus, indirectly, the products and investments—of many different companies. LINK IT UP Visit this website (https://openstax.org/l/austerebaltic/) to read an article about how austerity can work. Then visit this website (https://openstax.org/l/counteraustere) for another perspective on austerity. In this chapter, we discussed the basic mechanisms of financial markets. (A more advanced course in economics or finance will consider more sophisticated tools.) The fundamentals of those financial capital markets remain the same: Firms are trying to raise financial capital and households are looking for a desirable combination of rate of return, risk, and liquidity. Financial markets are society’s mechanisms for bringing together these forces of demand and supply. BRING IT HOME The Housing Bubble and the Financial Crisis of 2007 The housing boom and bust in the United States, and the resulting multi-trillion-dollar decline in home equity, began with the fall of home prices starting in 2007. As home values dipped, many home prices fell below the amount the borrower owed on the mortgage and owners stopped paying and defaulted on their loan. Banks found that their assets (loans) became worthless. Many financial institutions around the world had invested in mortgage-backed securities, or had purchased insurance on mortgage-backed securities. When housing prices collapsed, the value of those financial assets collapsed as well. The asset side of the banks’ balance sheets dropped, causing bank failures and bank runs. Around the globe, financial institutions were bankrupted or nearly so. The result was a large decrease in lending and borrowing, or a freezing up of available credit. When credit dries up, the economy is on its knees. The crisis was not limited to the United States. Iceland, Ireland, the United Kingdom, Spain, Portugal, and Greece all had similar housing boom and bust cycles, and similar credit freezes. If businesses cannot access financial capital, they cannot make physical capital investments. Those investments ultimately lead to job creation. When credit dried up, businesses invested less, and they ultimately laid off millions of workers. This caused incomes to drop, which caused demand to drop. In turn businesses sold less, so they laid off more workers. Compounding these events, as economic conditions worsened, financial institutions were even less likely to make loans. To make matters even worse, as businesses sold less, their expected future profit decreased, and this led to a drop in stock prices. Combining all these effects led to major decreases in incomes, demand, consumption, and employment, and to the Great Recession, which in the United States officially lasted from December 2007 to June 2009. During this time, the unemployment rate rose from 5% to a peak of 10.1%. Four years after the recession officially ended, unemployment was still stubbornly high, at 7.6%, and 11.8 million people were still unemployed. As the world’s leading consumer, if the United States goes into recession, it usually drags other countries down with it. The Great Recession was no exception. With few exceptions, U.S. trading partners also entered into recessions of their own, of varying lengths, or suffered slower economic growth. Like the United States, many European countries also gave direct financial assistance, so-called bailouts, to the institutions that make up their financial markets. There was good reason to do this. Financial markets bridge the gap between demanders and suppliers of financial capital. These institutions and markets need to function in order for an economy to invest in new financial capital. However, much of this bailout money was borrowed, and this borrowed money contributed to another crisis in Europe. Because of the impact on their budgets of the financial crisis and the resulting bailouts, many countries found themselves with unsustainably high deficits. They chose to undertake austerity measures, large decreases in government spending and large tax increases, in order to reduce their deficits. Greece, Ireland, Spain, and Portugal all had to undertake relatively severe austerity measures. The ramifications of this crisis have spread. Economists even called into question the euro’s viability.

Key Terms

actual rate of return the total rate of return, including capital gains and interest paid on an investment at the end of a time period bond a financial contract through which a borrower like a corporation, a city or state, or the federal government agrees to repay the amount that it borrowed and also a rate of interest over a period of time in the future bond yield the rate of return a bond is expected to pay at the time of purchase bondholder someone who owns bonds and receives the interest payments capital gain a financial gain from buying an asset, like a share of stock or a house, and later selling it at a higher price certificate of deposit (CD) a mechanism for a saver to deposit funds at a bank and promise to leave them at the bank for a time, in exchange for a higher interest rate checking account a bank account that typically pays little or no interest, but that gives easy access to money, either by writing a check or by using a “debit card” compound interest an interest rate calculation on the principal plus the accumulated interest corporate bond a bond issued by firms that wish to borrow corporate governance the name economists give to the institutions that are supposed to watch over top executives in companies that shareholders own corporation a business owned by shareholders who have limited liability for the company’s debt yet a share of the company’s profits; may be private or public and may or may not have publicly-traded stock coupon rate the interest rate paid on a bond; can be annual or semi-annual debit card a card that lets the person make purchases, and the financial institution immediately deducts cost from that person’s checking account diversification investing in a wide range of companies to reduce the level of risk dividend a direct payment from a firm to its shareholders equity the monetary value a homeowner would have after selling the house and repaying any outstanding bank loans used to buy the house expected rate of return how much a project or an investment is expected to return to the investor, either in future interest payments, capital gains, or increased profitability face value the amount that the bond issuer or borrower agrees to pay the investor financial intermediary an institution, like a bank, that receives money from savers and provides funds to borrowers high-yield bonds bonds that offer relatively high interest rates to compensate for their relatively high chance of default index fund a mutual fund that seeks only to mimic the market's overall performance initial public offering (IPO) the first sale of shares of stock by a firm to outside investors junk bonds see high-yield bonds liquidity refers to how easily one can exchange money or financial assets for a good or service maturity date the date that a borrower must repay a bond municipal bonds a bond issued by cities that wish to borrow mutual funds funds that buy a range of stocks or bonds from different companies, thus allowing an investor an easy way to diversify partnership a company run by a group as opposed to an individual present value a bond’s current price at a given time private company a firm frequently owned by the people who generally run it on a day-to-day basis public company a firm that has sold stock to the public, which in turn investors then can buy and sell risk a measure of the uncertainty of that project’s profitability savings account a bank account that pays an interest rate, but withdrawing money typically requires a trip to the bank or an automatic teller machine