ss-2018:ECONOMICS_FINANCIAL_LITERACY:18ss-2018:ECONOMICS_FINANCIAL_LITERACY:19
ss-2018:ECONOMICS_FINANCIAL_LITERACY:18 Different costs and benefits are associated with saving and investing alternatives.
ss-2018:ECONOMICS_FINANCIAL_LITERACY:19 Banks, brokerages and insurance companies provide access to investments such as certificates of deposit, stocks, bonds and mutual funds.
Learning goal: Explain the different costs and benefits associated with saving and investing alternatives, and describe how banks, brokerages and insurance companies provide access to investments such as certificates of deposit, stocks, bonds and mutual funds.
Comparing alternatives: four dimensions. Every saving or investing alternative can be compared on four dimensions. Return is what the money earns: interest, dividends or growth in price. Risk is the chance that the return will be lower than expected or that money will be lost. Liquidity is how quickly and cheaply the asset can be turned into cash without losing value. Costs include fees, penalties, commissions, fund expenses and taxes. A central principle is the risk-return trade-off: alternatives that offer higher expected returns generally carry more risk. No alternative is best on every dimension, so the right choice depends on the goal and time horizon. Money needed next month should be liquid and safe; money for retirement 40 years away can accept more short-term risk in exchange for higher expected long-run growth.
Savings accounts at banks and credit unions are highly liquid and very safe. Deposits at insured banks are protected by the Federal Deposit Insurance Corporation (FDIC), and deposits at federally insured credit unions by the National Credit Union Administration, generally up to 250,000 dollars per depositor, per institution, per ownership category. The cost is a low return that may not keep up with inflation, and some accounts charge fees.
Certificates of deposit (CDs) are deposits that you agree to leave with a bank or credit union for a fixed term, such as 6 months or 3 years, in exchange for a fixed interest rate that is usually higher than a savings account's. CDs are federally insured on the same terms as deposits. The main cost is lower liquidity: withdrawing early usually triggers a penalty, often several months of interest.
Bonds are loans an investor makes to a government or corporation. The issuer typically pays interest (the coupon) on a schedule and repays the face value at maturity. Bonds generally carry more risk than insured deposits: the issuer might default, and if interest rates rise, the market price of an existing bond falls, so an investor who sells before maturity may lose money. U.S. Treasury bonds carry very little default risk; corporate bonds carry more and usually pay more to compensate.
Stocks are shares of ownership in a corporation. Shareholders may receive dividends and gain if the price rises, but prices can fall sharply, and a company can fail, wiping out its shares' value. Over long periods, broad groups of stocks in the United States have historically returned more than bonds or savings, but with large ups and downs along the way and no guarantee that the past will repeat.
Mutual funds pool money from many investors to buy a collection of stocks, bonds or both, often but not always diversified (some funds concentrate on one industry or region), run by a professional manager or designed to track an index. Diversification, holding many different assets, reduces the damage any one company's failure can do. Costs include the expense ratio and sometimes sales charges; risk depends on what the fund holds.
Institutions that provide access. Banks (and credit unions) accept deposits, offer savings accounts and CDs, and many offer investment services through affiliated brokerage units. Brokerages are firms that buy and sell securities for customers; through a brokerage account an investor can buy stocks, bonds and mutual funds, and many brokerages also sell CDs issued by banks. Brokerage accounts are not FDIC-insured against investment losses; the Securities Investor Protection Corporation (SIPC) protects customers, within limits (up to 500,000 dollars per customer, of which no more than 250,000 dollars may be cash), if a member brokerage fails and customer assets are missing, but it does not protect against a fall in market prices. Insurance companies sell annuities, contracts that can provide income payments, often in retirement, and some sell investment-linked policies and mutual funds through affiliates. Annuities often carry fees and surrender charges for early withdrawal.
A fully worked model. A hypothetical student has 2,000 dollars and a goal three years away. Alternative 1: a 3-year CD at 4% compounded annually. Value at maturity: 2,000 × 1.04^3 = 2,249.73 dollars. If interest compounded monthly at the same 4% annual rate, the value would be 2,000 × (1 + 0.04/12)^36 ≈ 2,254.54 dollars. Early withdrawal would cost a hypothetical penalty of three months of interest, 2,000 × 0.04 ÷ 12 × 3 = 20 dollars. Alternative 2: buy 20 shares of an invented stock at 30 dollars (600 dollars) with the rest in the CD. If the stock pays a 0.40-dollar annual dividend per share and its price falls to 27 dollars when the student needs the money, the shares are worth 540 dollars plus 24 dollars of dividends received over the three years (0.40 × 20 × 3), a total of 564 dollars and a loss of 36 dollars on that part. The price could also rise. For a goal only three years away, the CD's certainty may be worth more than the stock's higher possible return. That is the cost-benefit comparison in action.
The misconception. "Higher return is always better." A higher expected return is compensation for accepting risk; if you cannot afford the loss or need the money soon, the safer alternative may be the better decision.
Worked example 1 — a CD with annual compounding: 2,000 dollars at 4% for 3 years: A = 2,000 × 1.04^3 = 2,000 × 1.124864 = 2,249.73 dollars. Interest earned: 249.73 dollars. With monthly compounding at the same annual rate: 2,000 × (1.003333…)^36 ≈ 2,254.54 dollars, 4.81 dollars more, because interest is added more often.
Worked example 2 — a bond held to maturity: A hypothetical 1,000-dollar bond with a 5% coupon pays 0.05 × 1,000 = 50 dollars of interest a year. Held for its 10-year life, it pays 10 × 50 = 500 dollars in interest and returns the 1,000-dollar face value, assuming the issuer does not default. If market interest rates rise and the investor must sell after two years, a buyer would pay less than 1,000 dollars, because new bonds pay more; that is interest-rate risk.
Worked example 3 — comparing liquidity costs: A hypothetical investor needs 2,000 dollars after one year. From a savings account paying 1%: no penalty, balance about 2,020 dollars. From a 3-year CD at 4%: one year of interest is 80 dollars, minus a hypothetical three-month-interest penalty of 20 dollars, leaving about 60 dollars of interest. From a stock fund: the value could be above or below 2,000 dollars, since nothing is guaranteed. The best alternative depends on how sure the need for the money is.
Alternatives comparison record: Build a table with rows for savings account, CD, bond, stock and mutual fund, and columns for return, risk, liquidity, costs and the institution that provides access (bank, credit union, brokerage or insurance company). For bonds, stocks and mutual funds, first name the representative product you are rating, such as a U.S. Treasury bond, one company's stock or a broad stock index fund. Rate return, risk, liquidity and costs as low, medium or high with a one-line reason; in the institution column, list the institution types rather than a rating.
Independent performance: A hypothetical client has three goals: an emergency fund, a car in three years and retirement in 45 years. Write a recommendation memo (not advice to a real person) matching each goal to one or two saving or investing alternatives. Success criteria: you explain the risk-return trade-off and liquidity; for each goal you state at least one cost and one benefit of your chosen alternative; you name the type of institution that provides access and whether deposit insurance applies; you include one compound-interest calculation with the formula and assumptions shown; and you explain why the same alternative is not right for all three goals.
An adult may read the prompts aloud. Answer independently with words, objects, drawings or a demonstration before opening the answer guide. Award 1 point for a correct result or claim and 1 point for a matching explanation or demonstration; where a question asks only for a result (a corrected sentence, a spelling, a count), a fully correct result earns both points, and the answer guide shows what a complete response contains. Record prompting separately. The total (two points per question) is local practice feedback, not an Ohio proficiency level.
Name the four dimensions on which saving and investing alternatives can be compared.
Return (what it earns), risk (chance of lower return or loss), liquidity (how easily it becomes cash without losing value) and costs (fees, penalties, commissions, expenses, taxes).
Explain the risk-return trade-off with an example.
Alternatives with higher expected returns generally carry more risk. A savings account is very safe but pays little; broad groups of U.S. stocks have historically returned more over long periods, with no guarantee for any one stock or period, but can lose much of their value in a short time.
Compute the value of 2,000 dollars in a 3-year CD at 4% compounded annually.
2,000 × 1.04^3 = 2,000 × 1.124864 = 2,249.73 dollars, so 249.73 dollars of interest, assuming it is held to maturity.
Why is a CD less liquid than a savings account, and what is the cost of that?
A CD commits the money for a fixed term; withdrawing early usually triggers a penalty, often several months of interest. In exchange, the CD usually pays a higher fixed rate.
Explain what a bond is and name two risks of owning one.
A bond is a loan to a government or corporation that pays interest and returns the face value at maturity. Risks include default, where the issuer fails to pay, and interest-rate risk, where rising market rates lower the bond's price if it is sold before maturity.
How do mutual funds reduce risk, and what cost do they carry?
Many funds pool investors' money to hold many assets, so the failure of one company has a smaller effect: diversification. How much risk is reduced depends on what the fund holds, and diversification does not remove the risk of a market-wide fall. They charge an expense ratio and sometimes sales charges.
Which institutions provide access to CDs, stocks, bonds and mutual funds?
Banks and credit unions provide CDs and savings accounts; brokerages provide stocks, bonds, mutual funds and brokered CDs; insurance companies provide annuities and, through affiliates, some investment products.
A student believes an account at a brokerage is protected by the FDIC against losses. Correct this.
FDIC insurance covers deposits at insured banks, not investment losses. Brokerage customers may have SIPC protection, within limits, if the brokerage itself fails and assets are missing, but neither protects against a decline in the market price of investments.