Introduction to Economics

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Introduction to Economics

• Linking Personal Investment with the US Economy
• Macroeconomics

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Econ 109 Class Page

• Econ Home Page http//www.econ.ucsb.edu

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Labs(sections) 12617 F 900-950 AM Jalama
Lab, Phelps 1517 MCL 12625 M 200-250
PM Miramar Lab, Phelps 1526 12633 M 700-750
PM Miramar Lab, Phelps 1526 12641 W 800-850
AM Miramar Lab, Phelps 1526 12658 T 630- 720
PM Miramar Lab, Phelps 1526 12666 F 100-150
PM Ledbetter Lab, Phelps 1530
Checking Instructional Computing Lab Scedules
http//www.ic.ucsb.edu/faculty/labs/
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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

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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 OSullivan and Sheffrin, Ch. 20,
Measuring a Nations Production and Income
emphasis measuring the ouput of the economy,
circular flow OSullivan 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.
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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

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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

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Life is Risky How to Cope?

• Protect against inflation
• dont put all your money in cash or checking
• hedge your bets, dont bet on just one market but
  diversify among markets
• real estate
• bonds
• stocks
• hedge your bets, diversify within markets
• laddering bonds
• stock index fund

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Inflation
Http//stats.bls.gov/eag/eag.us.htm
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Erosion of Purchasing Power
7289
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182,335
41,500
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30-Year Mortgage Rate of Interest
Http//research.stlouisfed.org/fred2/
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Interest Rate Vs. Length (Maturity) of the
Treasury Bond
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Http//www.publidebt.treas.gov/sec/sectrdir.htm
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Dow Jones Industrials Index
http//www.quicken.com
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Growth Rate 13 per Year
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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

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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

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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

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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

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Average 1 per month
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UC Funds Equity Vs. Insurance

• 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

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Measures of Average Rate of Return and
Variability Mean Std. Dev.
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Mean Returns Standard Deviations
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Efficient Portfolio Most Return for Given Risk
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Efficient Portfolio Most Return for Given Risk
This frontier shows the efficient (best) options
for investing, the first step of the economic
paradigm
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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
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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

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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
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Efficient Portfolio Most Return for Given Risk
Investor A very risk averse
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Efficient Investment Portfolio
Investor B not very risk averse
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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

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Growth Rate 13 per Year
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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

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Two Ways to Grow Your Wealth

• Savings increases your wealth
• rate of return adds to your wealth
• Combine these two for rapid growth

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Rate of Growth of Personal Wealth
savings, s
increase in wealth, ?w

Stock of wealth, w

yield, rw
rate of return, r
rate of growth of wealth, ?w/w ? rate of return,
r savings/wealth
?w/w ? r s/w
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Relative Importance of Savings

• 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

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Years to Double Wealth
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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
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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

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SummaryHow to Cope Simplify
Investment Strategy Buy and Hold Step 1
Save Step 2 Diversify, i.e keep a cash reserve,
buy a house, hold some treasury bonds,invest in
stock index fund with IRA or 401 k.
Using the Economic Paradigm to maximize return
for a given risk level
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Investment Principles or Maxims

• Dont put all of your eggs in one basket
• hold a diversified portfolio
• cash
• bonds
• stocks
• real estate
• advantage of a mutual fund or stock index fund
• instead of holding one stock, e.g. Coca-Cola, you
  hold a bundle of stocks
• Choose the asset with the highest reward for a
  given level of risk

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Part IV

• Value of a share of stock
• depends on the stream of expected future net
  earnings per share
• The Impact of the Business Cycle on Corporate
  Profits

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Your Stocks
Market Indices
corporate earnings(profits)
The Economy
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Tracking Assets and Markets

• What is the relationship between the monthly rate
  of return on the UC Index Fund and an index of
  the stock market, such as the Standard and Poors
  Index of 500 Stocks (SP 500) ?

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Example The UC Index Fund and the Standard
Poors 500

• mean rate of return on the UC Index Fund varies
  with the mean rate of return on Standard Poors
  Index of 500 Stocks
• capital asset pricing model

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Sources of Information stock prices

• Daily Quotes
• Business Section of Los Angeles Times
• Wall Street Journal
• Internet graphics
• http//bigcharts.marketwatch.com/
• http//www.quicken.com/investments

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Percentage Changes in IBM Versus the Dow
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Where does the growth in financial wealth come
from?

• What is the relationship between financial
  markets and the economy?

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http//www.globalexposure.com/
Last Ten Years
1948-
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Corporate profits after taxes

• doubled from 160 billion in early 1987 to 320
  billion in early 1994
• doubling in about seven years implies an average
  rate of growth of about 10 per year
• this rate of growth is comparable to the 11 rate
  of growth in the Dow since 1986

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Economic Concept

• present value of a stream of expected future net
  earnings, or profits, per share
• PV(t) ENE(t) ENE(t1)/(1i)
• may know this years net earnings, NE(t)
• your expectations of the future affect your best
  guess for next year, ENE(t1)
• at an interest rate of 7, 1.07 next year is
  equivalent to a 1 this year
• to compare dollar values for different years,
  they have to be discounted to a common year
• PV(t) ENE(t) ENE(t1)/(1i) ENE(t2)/(1i)2
  ...

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Income-Expense Statement for an Individual
Income
Expenditure
Savings
Income-Expense Statement for a Business Firm
Gross Revenue
Cost
Profit
(net revenue, net earnings)
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Your Stocks
Market Indices
corporate earnings(profits)
Index of Leading Economic Indicators Gross
Domestic Product Unemployment Rate
The Economy
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Index of Leading Indicators
1948-
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Labs Resources for Economists on the
Internet http//rfe.wustl.edu/
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The US Business Cycle

• expansions, or recoveries, the period from trough
  to peak, tend to last a lot longer than
  recessions, the period from peak to trough

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US Postwar Expansions
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US Business Cycle

• Note the long expansions in the eighties and the
  nineties
• is there a new economic regime or order?
• are business cycles a relic of the past?
• Note the long expansion in the sixties
• economists then talked about fine tuning the
  economy
• then came along the problems of the seventies
• a couple of recessions
• inflation

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Summary-Vocabulary-Concepts

• capital asset pricing model
• market risk
• asset specific risk
• stocks beta, ?
• moving average
• exponential growth
• Dow Jones Industrials
• present value

• net earnings per share
• expectations
• discount factor
• corporate profits after taxes
• business cycle
• peak
• trough
• index of leading indicators