Introduction to Economics

1. Introduction to Economics Linking Personal Investment with the US Economy Macroeconomics

2. Econ 109 Class Page • Econ Home Page:http://www.econ.ucsb.edu

3. Labs(sections) • 12617 F 9:00-9:50 AM Jalama Lab, Phelps 1517 • MCL 12625 M 2:00-2:50 PM Miramar Lab, Phelps 1526 • 12633 M 7:00-7:50 PM Miramar Lab, Phelps 1526 • 12641 W 8:00-8:50 AM Miramar Lab, Phelps 1526 • 12658 T 6:30- 7:20 PM Miramar Lab, Phelps 1526 • 12666 F 1:00-1:50 PM Ledbetter Lab, Phelps 1530 Checking Instructional Computing Lab Scedules http://www.ic.ucsb.edu/faculty/labs/

4. Lecture Outline • Guidelines for personal financial well-being • Bonds • Stocks • Choosing an efficient portfolio • The best portfolio for you • Making Your Wealth Grow • Where does the long run growth in stocks come from? Growth in corporate profits (net earnings), which in turn depends on the economy doing well

5. Part Two Macroeconomics and the US Economy 5. Thursday, Oct. 10, Lecture Five: "Capital Asset Pricing Model" Tracking asset markets and the US economy capital asset pricing model Growth rate of your personal wealth Value of a share of stock The impact of business cycles on corporate profits Reading Assignment: O’Sullivan and Sheffrin, Ch. 20, “Measuring a Nation’s Production and Income” emphasis: measuring the ouput of the economy, circular flow O’Sullivan and Sheffrin, Ch. 21, “Unemployment and Inflation” Problems O & S Text p. 434: 1, 5, 6, 7, 8, 9,10,11 p. 450: 1, 2, 3, 4, 5, 6, 7, 8 Tuesday, Oct. 22 , 25 minute QUIZ, You will need scantron sheet and #2 pencil.

6. Part I • Guidelines for Personal Finance, Summary • Life is Risky, How to Cope? • Risk from the Economy, e.g. inflation • Market Risk, e.g. stocks, bonds, real estate

7. Guidelines for Personal Finance • Keep you expenditures within your means • pay off your credit card debt • Save 10% of your income • pay yourself first • Diversify your investments • cash, for emergencies • housing, to build wealth and provide shelter • treasury bonds, as a safe investment • stock index fund, for growing your wealth

8. Life is Risky; How to Cope? • Protect against inflation • don’t put all your money in cash or checking • hedge your bets, don’t bet on just one market but diversify among markets • real estate • bonds • stocks • hedge your bets, diversify within markets • laddering bonds • stock index fund

9. Inflation Http://stats.bls.gov/eag/eag.us.htm

10. Erosion of Purchasing Power $7289

11. $182,335 $41,500

12. 30-Year Mortgage Rate of Interest Http://research.stlouisfed.org/fred2/

16. Interest Rate Vs. Length (Maturity) of the Treasury Bond

17. Http://www.publidebt.treas.gov/sec/sectrdir.htm

20. Dow Jones Industrials Index http://www.quicken.com

21. Growth Rate 13% per Year

22. Part II • Choosing among investment options, the efficient portfolio • example: six UC investment funds • tradeoff: the higher the rate of return, the higher the risk • called Markowitz Portfolio Analysis • Choosing the best portfolio for you

23. Example: UC Funds • Suppose you invest up to $10,000 per year in a tax sheltered 403(b) plan • you have to save $10,000, but you would have to pay income taxes if you took it as income • UC investment alternatives • guaranteed insurance contract(GIC) • savings fund • money market fund • bond fund • stock index fund • multi-asset fund

24. Investment Concepts • monthly return for June 2001 on an asset • price(June) - price(May) + dividends • price(June) - price(May): capital gain(loss) • dividends(interest): income from stocks(bonds) • monthly rate of return for June 2001 • [price(June) - price(May) + dividends]/price(May) • in %, multiply by 100 • annual rate: multiply by 12

25. Example: UC Funds/Mutual Funds • Sources of information on UC funds • monthly, quarterly, annual, etc. rates of return • internet: http://atyourservice.ucop.edu • Notice, a publication of the UC Academic Senate • Source of Information on Mutual Funds • quarterly • The Wall Street Journal, Mutual Funds Quarterly Review, e.g. extra section in July 3, 1997 Journal

29. Average = 1% per month

30. Insurance steady at a rate of return of about 0.6 per month or 7.2% per year does not vary much never negative Equity rate of return varies a lot from month to month range of rates of return from about plus 9% in Mar. ‘00 to minus 13% in Aug ‘98 can turn negative: 29 months out of 72 UC Funds: Equity Vs. Insurance

33. Measures of Average Rate of Return and Variability: Mean & Std. Dev.

34. Mean Returns & Standard Deviations

35. Efficient Portfolio: Most Return for Given Risk

36. Efficient Portfolio: Most Return for Given Risk This frontier shows the efficient (best) options for investing, the first step of the economic paradigm

37. Efficient Portfolio: Most Return for Given Risk Slope is the second step of the paradigm, determining values: Market Price of Risk: 0.1% return per month for every 1% of variability per month

38. Your portfolio should be on the efficient frontier • But where on the frontier? • depends on your taste for reward and risk • reward, i.e. the mean rate of return is a good • risk is a bad

39. Economic Paradigm: Valuation of Mean Return and Risk Assumption: Mean Return is Good, Risk is Bad: U =U(M,R) better Mean Return, M worse B C Iso - Preference Curves A Risk, R Prefer B to A; Prefer B to C

40. Efficient Portfolio: Most Return for Given Risk Investor A: very risk averse

41. Efficient Investment Portfolio Investor B: not very risk averse

42. Part III How do you make your nest egg grow? • Do you need to take risks and get a super high rate of return? • not if your ratio of savings to wealth is high • Strategy for the Long Run: Buy and Hold a Stock Index Fund

43. Growth Rate 13% per Year

44. Invest in A Stock Index Fund • Exponential Growth • Historically: 20th Century, 11% per year • Since 1986: 13% per year • Betting that history will repeat itself

45. Two Ways to Grow Your Wealth • Savings: increases your wealth • rate of return: adds to your wealth • Combine these two for rapid growth

46. Rate of Growth of Personal Wealth savings, s increase in wealth, w + Stock of wealth, w + yield, r*w rate of return, r rate of growth of wealth, w/w  rate of return, r + savings/wealth w/w  r + s/w

47. Younger Years income & savings are lower wealth is smaller ratio of savings to wealth may be high savings is most important, rate of return less so example income of $60,000 savings of $6,000 wealth of $50,000 ratio of savings to wealth of 0.12 Older Years wealth accumulates ratio of savings to wealth falls rate of return on wealth becomes more important example income of $100,000 savings of $20,000 wealth of $500,000 ratio of savings to wealth of 0.04 Relative Importance of Savings

48. Years to Double Wealth

49. rate of growth of wealth, w/w w/w r + s/w rate of return on wealth, r 12% 8% 4% 0 ratio of savings to wealth, s/w 4% 8% 12%

50. Rate of Growth of Personal Wealth • If the rate of return, r, on wealth is zero • then the only source of growth in wealth is savings: w/w = s/w • i.e. the only change in wealth, w, is savings: w = s • If savings is zero • then the only source of growth in wealth is rate of return, r, and wealth will grow exponentially at the rate r: w/w = r