INVESTMENT GUIDEBOOKA Supplement for the Indiana Stock Market Simulation

The Indiana Stock Market Simulation (SMS) is an excellent tool for familiarizing you with financial markets and investments, especially investments in the stock market. SMS does this in a way that is interesting and exciting. Additionally, it helps provide a very practical way to strengthen math, research, communication, analytical and teamwork skills.

Although the SMS lasts only ten weeks, in the real world individuals invest for much longer periods of time and consider many investment options besides stocks in their portfolio decisions. It is very important that you understand these various investment options because these days you have much more control over your own savings and retirement planning. For example, many of you will someday direct your own IRA’s and 401(k) savings and retirement accounts.

The Stock Market Simulation gives you the basics, teaching you the pros and cons of including stocks in your portfolios. This valuable booklet takes you beyond this, teaching you about other investment options to consider in reaching broader savings and retirement goals.

A Publication of the

Guidebook written by Donald G. Fell, president of the Florida Council on Economic Education, with editorial assistance provided by Larry Silver, senior vice president of marketing, Raymond James Financial Inc.

What will this Guidebook do for you?

Throughout our lives we will face a variety of challenges that will be much easier to meet if we have done proper financial planning. Certainly not all individuals will make the same income during their career; however, many of the financial challenges individuals face are the same regardless of income level. In both cases, though, individuals must know how to develop a financial plan to accomplish the goals they feel are important. This guidebook is designed to help students and their parents understand, in very concise, non-technical language, the purpose of a financial plan and the types of investments to be considered for the financial plan to have the opportunity to be realized.

All too often we hear of types of investments that offer very high returns with seemingly little or no risk. When we hear of investments such as these we need to remember that if it seems too good to be true, it probably is. As you go through this guidebook you will have an opportunity to read about many types of investments, and in each case both the risk and reward will be described. To make this understanding even easier, we will use an investment pyramid to show the relationship between risk and reward.

For students, the idea of a financial plan may seem like something that can be put off until schooling is complete, a career is begun and major purchases have been paid for. But, this is not the case. Financial planning should start at a young age, not when someone is 10 to 15 years from retirement.

Usually, when someone first hears of a financial plan they think of saving money for a long period of time for retirement, but true financial planning goes far beyond retirement planning. A good financial plan may additionally have more short-term goals to help someone save to make a major purchase, such as a car, or save to provide money for technical school or college. And, as you will see as you read through this guidebook, no matter what your age, you can develop your own financial plan to meet the long and short-term goals you set for yourself. Certainly, as people grow older and take on more responsibility, they will need to review their financial plan to bring it in line with any goals that might have changed, but the discipline of establishing a financial plan at a young age will make financial planning much easier later in one’s life.

Financial planning requires you to do your homework, and you should want to do this because it’s your money you’re going to be dealing with. You should want to know where you’re putting your money, what type of return you should expect, what the risks are with the types of investment you choose and how long you have to achieve your goals.

It is the goal of this guidebook to provide you with enough familiarity about several types of investments that you can then feel comfortable in getting additional information, reviewing it and making your investment decision, either with a financial advisor or on your own, based on the goals you have established.

Financial Planning Pyramid

This pyramid is designed to show the traditional relationship between risk and return of the noted investments. In all cases, investors should seek additional information about each type of investment. For example, some mutual funds or stocks carry more risk than others, and mutual funds vary in their requirement of a higher load and/or management charge. Additionally, some corporate bonds carry more risk than others.

Building a Financial PlanWhere to begin?

If someone is learning gymnastics they don’t begin by trying a triple back flip, a very risky and very rewarding routine if completed successfully. Instead, they begin with the basics, involving little risk and some reward, then build up to more sophisticated routines. The same is true with investments begin with the basics, then progress up to higher levels of sophistication.

The Foundation

Just as the wording in the pyramid notes, you need to have a solid foundation for your financial plan. That foundation is best built by putting money into types of investments that offer the least potential for risk such as savings accounts, certificates of deposit, money market accounts, interest bearing checking accounts and whole life insurance. As with all types of investments there is a down side, and the down side of these investments is that their return is relatively low and generally taxable. But, remember, the purpose of these investments is not a high return; it is safety. This is the foundation of our financial plan, and we want to make sure this foundation is not at risk.

What are these types of investments and what do they do for me?

Savings account, certificates of deposit (CDs) and NOW (negotiable order of withdrawal) accounts which are savings accounts on which checks may be drawn, are quite common and familiar to most people. A savings account is an account in a financial institution such as a bank, credit union or savings and loan that pays the holder a rate of interest.

With a regular savings account deposits are made at any time and withdrawals may also be made at any time without any penalty.

There may be a minimum amount required to open a savings account, but the amount is usually small and may range from $5 up to $100. Usually additions to the account may be made in any amount. Interest is calculated in a variety of ways, including daily, monthly, quarterly or yearly; and the rate may change, but usually only slightly. These accounts are insured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000 per account. Certificates of deposit are similar to a regular or passbook savings account, except when someone puts money into a certificate of deposit they agree to leave the money for a certain period of time. These time periods may range from as short as one month to up to more than six years. CDs pay a slightly higher rate of interest than a regular savings account, but if the money is needed before the CD matures the interest amount is recalculated and a penalty is imposed. As a general rule, if someone doesn’t think they can leave a CD in until it matures, the money should not be put in a CD. Some other type of investment should be selected.

Interest bearing checking accounts are a type of checking account that financial institutions pay interest on money deposited in the account. There is a minimum deposit required to have this type of account and it may range from $1,000 - $2,500. The FDIC insures these accounts up to $100,000 per account. Rates on these accounts may fluctuate, and a cost may be charged for maintaining the account.

Fixed annuities and traditional life insurance offer two other relatively risk free investments and are included in the foundation of a financial plan. While the word “annuity” may be new to you, you are familiar with at least one type of annuity--social security. This is an annuity managed by the U.S. Government that will provide a monthly payment or benefit, known as a defined benefit, from the time individuals retire until they die. Individuals may choose to have an additional annuity, a private annuity, which they buy from an insurance company or other type of investment firm. When someone buys a private annuity they agree to pay a lump sum or an agreed upon amount of money per month for a certain period of time, perhaps $100 per month until age 62, in exchange for the promise of the investment firm to pay the person a certain (defined) amount for a specified period of time. The monthly

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payments one makes is called a premium, and the amount one receives at the end of the annuity period is known as the benefit. These types of annuities are not government insured.

Traditional life insurance provides someone with both a stated amount of insurance as well as cash value. Known primarily as whole life, this type of insurance provides an amount of money, known as the face value, to the person(s) named as a beneficiary when the person insured by the policy dies. The payments made to the beneficiary may either be in one payment, known as a lump sum payment, or as monthly payments over an agreed upon time period. However, before the death of the person insured by the life insurance policy, payments, known as premiums, are paid each year. Over time, cash value accumulates as a part of the policy, and if an individual lives to retirement they may choose to have the cash value paid to them each month over a period of time. In this case, during their working years they had insurance to protect their family in case of their death; and at retirement, if they chose to do so, they could use the accumulated cash value of the policy as an annuity benefit.

Another type of insurance is known as term insurance. This insurance offers payment of only the face amount of the policy at death, with no cash value accumulation. Because cash value does not accumulate in such a policy, it is cheaper to buy per $1,000 of coverage than other whole life insurance.

As with private annuities, insurance accounts are not government insured.

Terms

Annuity - a contract where payments are made for a specific period of time in return for receipt of a future series of payments. Social Security is a type of annuity.

Certificate of deposit - a type of savings account where investors agree to leave their money in the account for a specified period of time.

Fixed annuity - a contract whereby payments are made in return for payment of a set amount of money at some future date. Individuals must invest cash values of the annuity in a limited number of safe investments.

Interest bearing checking account - a checking account that pays interest to the owner of the account.

Money market account - an interest bearing checking account that is a type of mutual fund typically comprised of safe, highly liquid investments with a maturity of one year or less. Negotiable Order of Withdrawal (NOW Account) - a type of savings account on which checks may be drawn.

Savings account - deposits made at a financial institution that earn interest and may be withdrawn at any time and may not be used for checking purposes.

Term life insurance - a type of insurance that provides a death benefit to a named beneficiary upon the death of the insured.

Whole life insurance - a type of insurance that provides a death benefit to a named beneficiary and accumulates savings or cash value.

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Building on the FoundationSecure Investments, More Return, More Risk

A bond is a type of debt and is issued by either companies or governments to help them secure money to pay for certain projects. Bonds issued by companies are referred to as corporate bonds, and those issued by governments are either municipal bonds (issued by cities, counties or states) or U.S. government bonds (issued by the U.S. government).When someone buys a bond they are guaranteed interest payments, usually semi-annually; and they will receive the face value of the bond when it matures. Interest on municipal bonds is not taxed at the federal level, and interest on U.S. government bonds is not taxed at state or local levels.U.S. government bonds have the highest credit rating and offer the least risk of all these types of bonds because it is the U.S. government promising to pay interest as well as face value at maturity.

While municipal bonds also are considered very safe, the degree of safety depends on the ability of the city, county or state to make interest payments and pay off the bond at maturity. U.S. government bonds, as well as municipal bonds, may have maturity periods as long as 30 years.

Most corporate bonds also require that interest payments be made semi-annually and that the face value of the bond be paid at maturity. As with municipal bonds, the degree of safety of a corporate bond depends on the financial condition of the community issuing the bond. Organizations such as Moody’s and Standard & Poor’s provide ratings of bond issues, and before purchasing any corporate bond one should look up the rating of the bond.

In addition to these various types of bonds, investments such as blue chip stocks and income mutual funds offer a high degree of safety to an investor. Stocks represent part ownership (equity) in a company, and those stocks classified as blue chips are the stocks of the largest, most profitable companies. As a company grows and is profitable, shareholders may find that both their stock value and dividends on the stock rise; however, there is some risk that if the company does not grow or if it does not make a profit, its share price as well as its dividends may fall. It should be understood that by being able to sell shares of stock, companies may acquire financial capital required to expand.

Mutual funds represent part ownership of many stocks or bonds, and because an investor owns part of many stocks or bonds the risk may be minimized as compared to owning individual stocks or bonds. There are thousands of mutual funds to choose from, and each mutual fund has its own goal or objective. Some may strive for income while others may strive for growth, either long or short term.

Usually, those mutual funds that seek income are comprised of high quality corporate or government bonds or blue chip stocks. These are the types of mutual funds one seeks to purchase initially to minimize risk while still offering the potential of higher return than those investments in the Foundation category, and which also provide a potential hedge against inflation. Again, as with the bond ratings, one should seek reference materials from organizations such as Morningstar to get information on mutual funds concerning their individual objective as well as their past performance.

Corporate, municipal and U.S. government bonds, stocks and mutual funds may be purchased through securities firms as well as from many banks, credit unions, insurance companies and other financial institutions. The charge for purchasing these investments is known as a commission, and it is paid to the firm that buys the securities for an individual.

A common myth in investing is that one must have several thousand dollars to start buying mutual funds, stocks or bonds. This is simply not true. While the minimum amount required to purchase most bonds will be $1,000, a person may start purchasing mutual funds with as little as $100 to begin, and additions may be made in amounts as low as $50. A second investment myth is that the commission rate to purchase any of these investments is significant. Today, one may purchase these investments in a variety of ways, including over the Internet. Commissions may range from as low as 2.5% - 3.5 % of the value of the trade from a full service investment firm to no charge for a trade over the Internet. It must be understood that while the Internet trading firm may not charge any commission,

less service is provided through this source of trading than through the full service firm which usually provides services such as advice and research.

In recent years, through the introduction of the Individual Retirement Account (IRA) and 401(k) plans, individuals have been afforded opportunities to invest for their retirement. The individual owner of the IRA or 401(k) plan must determine the composition of their account, which may consist of stocks, bonds, mutual funds, certificates of deposit or other financial instruments. Obviously the level of risk and income of the IRA or 401(k) will depend on the choice of investments that comprise the account.

Terms

Blue chip stock - a unit of ownership in a large, well established firm.

Bond - loans made to governments or corporations.

Corporate bond - a bond issued by a corporation.

Debt - borrowing.

Equity - ownership.

401(k) plan - a retirement plan that allows an employee to set aside a specified amount of tax-deferred income.

Government bond - a bond issued by the United States Government.

Individual Retirement Account - a retirement account in which a person may deposit up to a stipulated amount each year with the deposits deductible from taxable income. Upon retirement both deposits and earnings on the account are taxable.

Morningstar - one of the firms that rates the investment quality of mutual funds.

Moody’s- one of the firms that rates the investment quality of stocks and bonds.

Municipal bond - a bond issued by a county, city, state government or special taxing district.

Mutual fund - a financial instrument that represents ownership of portions of a variety of stocks and bonds.

Standard & Poor’s - one of the firms that rates the investment quality of stocks and bonds.

Moving Beyond the Secure InvestmentsTargeting Growth

Once the Foundation and Secure investments have been made, it is time to consider those investments that offer growth. While growth types of investments will give us the opportunity of higher rewards, they also are higher risk than those in the previous two portions of the pyramid.

From the previous section we became familiar with stocks and mutual funds, and it was noted that stocks as well as mutual funds have varying degrees of risk. Those discussed in the previous section focused on very safe, secure investments--usually providing good income but little growth. Because our focus in this section is on growth, we will be looking at the types of stocks and mutual funds that meet this objective.

Companies that are not leaders in their field, not well established and that do not have a history of making profits may not be as secure as blue chips, but they may offer the potential for growth as they find new markets for their products or services and become profitable. Today many companies in the technology and telecommunications field might be considered growth stocks even though they may be making little or no profit. Individuals seek to purchase their stock because of the potential earnings of the company, but there is always the risk that the earnings may not occur. In this case the stock price may fall, not rise.

Growth mutual funds provide us an opportunity to purchase partial shares of many growth stocks, and in doing this we are still taking a risk, but less risk than if we put our money in only one particular stock. In this case, for example, a mutual fund might own shares in several technology or telecommunications companies, not just one.

Therefore, if one stock declines, there is still the possibility that other stocks in the mutual fund might rise, offsetting the decline in the price of the one stock. In this case we say we have diversified our investment, spreading our risk over several stocks, not just one.

Two additional considerations for growth include variable life insurance and variable annuities. Both these investments offer the same basic benefit as described in the Foundation section; however, when one chooses these types of investments in variable form, there is no guarantee of the cash value for the life insurance policy or the annuity benefit at the end of the annuity period. The traditional life insurance and annuity guaranteed specific returns, and the money paid to the firm for these investments is placed in such investments as government bonds, municipal bonds and certificates of deposit. When one chooses the variable life insurance or variable annuity, the firm places a portion of the investor’s payment (the premium) into investments with more risk, but also an opportunity for a higher rate of return. In this case, the cash value or annuity benefit will rise or fall, dependent on the fluctuation in the investments that comprise the basis for the cash value or annuity.

Terms

Diversification - reducing the level of risk by spreading investment purchases among several stocks or bonds.

Variable annuity - a contract whereby payments are made in return for payment of an unspecified amount of money at some future date. Payments during the period are put in bonds, stocks and other financial instruments and may fluctuate in value.

Variable life insurance - a type of insurance that provides a death benefit and whose cash values or savings are invested in a variety of stocks and bonds whose values fluctuate.

Looking for Greater Rewards,but Assuming More Risk

Once an individual has met the earlier steps in building their financial plan, they may wish to consider investments that offer even higher returns, but also involve assuming a much higher risk. It should be noted that when one looks to these types of investing, careful research must be done. This does not mean that in the earlier investment stages research is not important, but in this highest risk stage of investment research becomes doubly important because the types of investment are subject to much higher risk levels.

One type of investment that may carry the possibility of substantial gain, but which also is accompanied by a very high level of risk, is trading in commodities or futures contracts. A futures contract is an agreement between a buyer and seller whereby the buyer agrees to buy a stated

amount of a commodity (one contract) at some time in the future, usually less than a year from the time of purchase. The buyer puts up a percent of the money value of the total contract price as a deposit, and if the commodity price changes after the original agreement is made the value of the contract may rise or fall significantly. In either case the gain may be much more than the original deposit, or the loss may be much greater than the original deposit. When buying stocks the most someone can lose on a regular (non-margin) purchase is 100% of the investment; however, on commodity contracts one may lose significantly more than 100%.

Options are a type of investment based on futures prices, and when one buys an option they are buying the right to buy or sell an item (commodity, precious metal, stock, bond, currency) for a predetermined price during a certain time period. In other words, if someone buys an option, they are not buying the item itself; they are only buying the right to lock in a purchase price of the item for a certain time period.

If they want to purchase the item they have to use (exercise) their option. If the price of the item moves up during the time someone holds the option, they may sell and make a profit; however, if the price declines during this same time period the option becomes worthless. As a rule, options do offer an opportunity for a high return, but it should be emphasized that there is a very high risk associated with the purchase of options.

Other types of investments that offer very high returns but are accompanied by high levels of risk are works of art and precious metals. When making these types of purchases one must have knowledge about the item being purchased, including the market for resale. While the market for stocks, bonds and mutual funds is well known, the market for resale of artwork and precious metals is less well known and much smaller. If one decides to sell one of these items previously purchased as an investment, it must be understood that resale may be much more difficult and expensive than the resale of a stock, bond or mutual fund.

Terms

Futures - a contract made now for commodities to be bought or sold in the future.

Options - a contract that allows a buyer to purchase a stock or futures contract at an agreed to price during a specific time period.

Precious metals - a mined commodity such as gold, silver, or platinum, which is scarce.

Regulations and Safeguards for Investors

The securities industry is regulated by both federal and state regulators, with the regulations designed to protect investors and promote ethical standards in the securities industry. These regulations require full and fair disclosure of financial information by publicly traded companies; provide for the registration of brokers and dealers, and oversight of the offering and sale of securities to the public.

Additionally, the various stock exchanges conduct self-policing by setting and enforcing standards by companies whose securities are listed as well as by prescribing rules of conduct, minimal capital requirements and other standards for their own members.Examples of such regulatory and enforcement agencies include the Securities and Exchange Commission, The National Association of Securities Dealers, Inc., the New York Stock Exchange and the Indiana Secretary of State, Securities Division.

Understanding Ratings of Bonds and Preferred Stock

While several organizations rate the quality of bonds, the following two rating scales should provide a guide as to how these investments are evaluated:

Moody’s Standard & Poor’s Criteria

Aaa AAA Best quality, smallest degree of risk, “gilt edged”Aa AA High quality, small degree of riskA A Upper medium grade, some riskBaa BBB Medium grade, very slight speculationBa BB SpeculativeB B Speculative, vulnerable to nonpaymentCaa CCC Very speculative, may be approaching or in default

Self Check

It cannot be emphasized enough--we must know how to construct a financial plan based on sound principles designed to meet our long and short term financial goals. Below is a self-check to see how well you would do in developing a financial plan for each individual. Read through it carefully, and then make your recommendation. Following the self-check are some sample answers for each case. See how close you came to these answers in your response.

I. Samantha is 16, from a middle-income family living in a suburb and is completing her junior year in high school. She has worked part time for the past year, has $1,500 in a savings account and plans on working full time during the summer earning approximately $3,000, part time during her senior year earning $1,500 and full time the summer following graduation earning $3,000. Since her job is only 3 blocks from her home, she does not need a car for work purposes. After high school graduation she plans on attending the community college in her hometown and will live at home. Her family will pay for her tuition and books during community college and will only be able to pay $3,000 of her $6,000 yearly fee to attend her final two years of schooling at a university 150 miles from her home. What would be your recommendation to Samantha regarding how she should invest her money? Why? What would you advise Samantha NOT to do with her money? Why not?

II. Michael and Christi will both finish community college within the next month and both have secured jobs, Michael as an electronics technician and Christi as a paralegal. They will be married three weeks after graduation. They have no savings and $600 in checking accounts. They estimate they will be able to save $1,500 their first year of marriage and at least $2,000 their second year. What would you advise them to do with their savings? Why? What would you advise them NOT to do? Why not?

III. Luis and Maria have been married for 10 years, have 2 children ages 5 and 8, and have combined yearly income of $42,000. They have $3,000 in a savings account, $2,000 cash value in a whole life insurance policy and $5,000 in a certificate of deposit maturing in 9 months.

IV. George and Ruth are 55 years old, have 4 children who are married, have virtually no debts, $50,000 in certificates of deposit maturing in one year, $10,000 in growth mutual funds and $25,000 cash value in two life insurance policies. Their combined income is $90,000 per year, and they estimate they could save up to $30,000 per year if they had to; however, in the past they have chosen to travel, buy a small sailboat, dine out frequently and spend on a variety of items instead of saving as much as they could. They realize that they should have started saving for retirement long ago, but they can’t redo those years. What would you recommend they do regarding savings? What types of investments should they make? Why? What types of investments should they NOT make? Why?

V. Jennifer and Roberto, each 34 and with no children, were married for 10 years before they divorced one year ago. Both had been successful in their respective career, with Jennifer earning $75,000 per year and Roberto earning $70,000 per year. Once the property was split by the divorce, Jennifer received the following investments the couple had made: $5,000 in gold coins, $3,000 in rare coins, $10,000 in mutual funds (income mutual funds), $10,000 in artwork and $10,000 in a certificate of deposit maturing six months from now. Jennifer estimates that she will be able to save $3,000 during the next year and over $4,000 each subsequent year. How would you assess her present investments? Would you advise her to sell any of those investments? If so, which ones? How would you advise her to invest her yearly savings for the next 10 years? Would that change after 10 years? 20 years? 30 years? Why? What should she be investing in 20 years from now that you would not recommend for her at present? Why?

Answers to Sample Cases

I. Samantha is truly at the Foundation stage of the financial planning pyramid and should put her money in investments that are safe and liquid--that is, easily turned into cash to help her pay college costs. While she would like to earn a good rate of return on her investment, her primary concern is safety of principal. She should look at putting her money in certificates of deposit with maturity periods timed to provide her cash when she expects it to be needed. She should not put her money in investments with higher levels of risk such as stocks or other investments noted in the top three stages of the financial planning pyramid. Again, her goal is safety of principal to allow her to have money available to pay for college.

II. Michael and Christi should put the majority of their savings in a regular savings account for both years, but should also establish an IRA for long term-growth. Since they have no previous savings, their immediate concern is safety of principal, which is achieved through the savings account. The IRA offers long-term growth and does not have to include a high degree of risk. They should not invest in any investments noted in the top two areas of the financial planning triangle.

III. Luis and Maria have as one of their top financial goals the accumulation of enough funding to send both their children to college. To achieve this goal they will need to accumulate significant savings in a relatively short period of time. While they will need to invest in relatively safe investments, they do need some growth potential. Also, they need to guarantee that if either of them is not living at the time their children are ready for college, some college funds are provided through life insurance proceeds. Recommendations for them, in addition to life insurance, might include growth mutual funds or growth stocks, with perhaps some money placed in income mutual funds. They should not put their money in speculative investments that have a high-risk level. Traditional savings accounts and certificates of deposit do not provide the growth level they will need to generate the amount of money they will need for the college fund. They estimate they can save at least $3,000 per year for the next few years. They would like both their children to go to the college, which is in their hometown.

IV. George and Ruth are typical of many Americans waiting until a few years before retirement to realize they just don’t have enough saved to live on comfortably. Their life insurance does not really provide any financial stability since it is relatively small in proportion to their income level. Regarding their savings, they need to accumulate as much as possible during their remaining 8 - 10 working years. With savings capability of $30,000 per year, they could put their money into a mix of growth and income mutual funds, and perhaps some growth stocks. They also need some type of insurance to guarantee that in event of death, the surviving spouse has some income provided. At age 60 they might want to reexamine their investment mix, placing less in stocks and more in growth and income mutual funds. Upon retirement they might want to place less in growth mutual funds and more in income mutual funds. They probably should not invest in any of the investment choices in the high risk/speculative portion of the financial planning pyramid.

V. Most of Jennifer’s present investments primarily fall into the high risk / speculative category. If she feels comfortable at her present income with present expenses, she may choose to keep some of these investments but sell some others. The artwork and coins have the chance of appreciation, but that appreciation is not guaranteed. Since she is relatively young it probably is not best for her to hold income mutual funds. She might want to consider selling these and putting the money into growth mutual funds. For the next 10 years her savings should be put in investments with some growth possibility for example, growth mutual funds or growth stocks. Each subsequent 10 years she should reexamine her investments, and with each reexamination should reduce the risk level in her holdings so that by the time she is 64 her investments are in income mutual funds and other income producing investments. At this age, income, not growth, is not her primary investment goal.