1.) Background to Savings and Investments

Question 1

Define ‘saving’

Answer 1

The act of setting money aside, enabling the saver to build up a liquid reserve of money so that it is readily available for:

A sudden emergency or pre-planned purchase (precautionary)

And to provide cash to meet daily requirements (transactionary)

Question 2

Describe the characteristics that a saver would be looking for, when holding a financial asset

Answer 2

Capital security and preservation

Short-term access

Minimum risk

To the saver, the financial reward is of secondary importance, meaning that although their financial assets are secure, they will get a lower return on them

Question 3

Define ‘investment’

Answer 3

The expectations by those investing that they will receive some form of financial reward (speculative)

Question 4

Describe the characteristics that an investor would be looking for, when holding a financial asset

Answer 4

A regular income and/or capital growth from their investment

In order to achieve this, the investor is willing to accept a longer term and higher risk

Question 5

Define and briefly describe the 3 reasons, as identified by the economist John Maynard Keynes, for holding financial assets

Answer 5

Precautionary - saving for a rainy day

Transactionary - to meet day to day needs

Speculative - anticipation of a financial reward

Question 6

Give an example of cash investments

Answer 6

Bank and building society accounts that usually pay a return, in the form of interest

Question 7

Define the time frame (I.e. Short/long term), level of risk and level of reward associated with savings

Answer 7

Short term

Low risk

Low reward

Savings=short and low-low

Question 8

Define what speculation involves

Answer 8

Speculation involves a short time horizon with a potentially high reward by way of a capital gain.

For example, buying shares with a view to resell them quickly at a profit.

Question 9

Define the time frame (I.e. Short/long term), level of risk and level of reward associated with speculation

Answer 9

Short term

Higher risk

Potential for high reward

Speculation=Short-high-potentially high

Question 10

Define speculation

Answer 10

The act of trading in an asset, or conducting a financial transaction, that’s got a significant risk of losing most or all of the initial outlay, in expectation of a substantial gain.

Question 11

Define investment

Answer 11

An asset/item that’s purchased with the hope that it will generate income or appreciate in the future

Question 12

Define the various forms that investment returns can come in

Answer 12

Income, Capital gain or both

Question 13

Define the time frame (I.e. Short/long term), level of risk and level of reward associated with investment

Answer 13

Long term

Low to high risk

Potential for high reward

Investment=Long-low-high

Question 14

Define hoarding

Answer 14

The act of hanging onto an asset, e.g. Cash, to ensure that it is readily accessible when required and preventing other parties of knowing of its existence.

Hoarders have in the past stashed cash inside mattresses, etc

No return should be expected, and if the cash is hoarded for a significant amount of time, there’s the risk of capital loss due to the impact of inflation, and the declining purchasing power of money

Question 15

Briefly describe why hoarding is deemed high risk

Answer 15

The risk of theft or loss of the asset

Question 16

Define the time frame (I.e. Short/long term), level of risk and level of reward associated with hoarding

Answer 16

Short to long term

High risk

No reward

Question 17

Define ‘gambling’, in relation to investments

Answer 17

An ‘all or nothing’ situation in which the gambler stands to lose their entire stake in order to achieve a very high reward

Question 18

Define the time frame (I.e. Short/long term), level of risk and level of reward associated with gambling

Answer 18

Short term

Extremely high risk

Minimal chance of reward

Question 19

Give 5 examples of factors that individuals are influenced by, when saving and investing

Answer 19

(Note that these factors vary according to personal needs, wants and experiences):

Rate of return

Potential for capital growth

Risk of capital loss

Attitude towards risk

Time horizon (short term5 yrs)

Need for liquidity (the ease in which an asset can be converted into cash)

Simplicity (the ease in which an asset can be understood)

Tax efficiency - some products are tax-free; others deduct income at source whilst others pay gross interest

Question 20

Define the link between risk, time and return

Answer 20

The greater the risk and time involved, the greater the potential return

Question 21

Define the attitudes of ‘risk adverse’ investors

Answer 21

Dislike risk

Prefer certainty

Looking to eliminate risk if possible

Question 22

Define the attitudes of ‘risk neutral’ investors

Answer 22

Indifferent to risk or uncertainty, provided that their returns aren’t affected

Question 23

Define the attitudes of ‘risk preferring ‘ investors

Answer 23

Like taking risks and are fully aware of the potential consequences of taking risk, i.e. Capital loss/no return

Question 24

Define the 3 attitudes that different investors may hold towards risk

Answer 24

Risk adverse

Risk neutral

Risk preferring

Note that attitude to risk varies, and depends on circumstances. An individual can fall into a different risk profile: it isn’t safe to assume that a person who is risk-averse in one situation will always be risk-averse in another

Question 25

Give examples of the effects of investors being exposed to risk

Answer 25

All or part of their capital may be lost

Capital value will fluctuate in the short term, to the possible detriment of the investor

Income that is expected may not materialise, this may eventually affect the capital value

Question 26

Give 5 different examples of types of risk when making an investment

Answer 26

Systematic (market) risks

Unsystematic (specific) risks

Liquidity risk

Inflation risk

Interest rate risk

Currency risk

Business risk

Industry risk

Management risk

Question 27

Define systematic (market) risks

Answer 27

Sources of systematic risk include:

Liquidity

Inflation

Interest

Currency rates

…as they affect the entire market and can’t be avoided via diversification.

They affect the investment as a whole

They are usually outside the power of the investor and investment manager to influence

Question 28

Define liquidity risk

Answer 28

The risk that an asset can’t be traded quickly enough to avoid making a loss, or realising a profit.

This situation arises when an individual wants to trade an asset but cannot do so, as nobody else in the markets wants to.

If one party can’t find a party to trade with, the asset is illiquid, and as a result affects the person’s ability to trade and dispose of the asset

Note that, during the 2008 banking crisis, top high street banks avoided trading and lending to each other for fear of losing funds. This resulted in a loss of liquidity in the whole market.

Question 29

Define illiquid

Answer 29

The state of a security or other asset that cannot easily be sold or exchanged for cash without a substantial loss in value. Illiquid assets also cannot be sold quickly because of a lack of ready and willing investors or speculators to purchase the asset.

The lack of ready buyers also leads to larger discrepancies between the asking price (from the seller) and the bidding price (from a buyer) than would be found in an orderly market with daily trading activity.

Question 30

Define inflation risk

Answer 30

The possibility that the value of assets or income will decrease as inflation shrinks the purchasing power of money.

Inflation causes money to decrease in value, regardless of whether the money is invested or not.

Question 31

Define inflation

Answer 31

A rise in the general level of prices of goods and services in an economy over a period of time, resulting in the ability to buy less with the same amount of money

Question 32

Briefly describe how UK inflation is measured

Answer 32

UK inflation is measured by the RPI (Retail Price Index), whereby a weighted basket of goods and services bought by an average family is prices, and the percentage change of those goods is calculated over time.

Question 33

Define what RPI stands for?

Answer 33

Retail Price Index

Question 34

Define interest rate risk

Answer 34

The outlook for the levels of interest rates, and the length of time that interest rates are at certain levels greatly affects the value of most investments. i.e. Rising interest rates=falling price of stocks and shares

One reason for this fall is that higher interest rates provide greater return with lower risk. Therefore, investors holding shares will require higher returns from their share in return for the greater risk of holding shares.

Question 35

Define currency risk

Answer 35

A form of risk that arises from the change in price of one currency against another, thus making it more cheaper or more expensive to transact.

Note that whenever investors have assets across international borders, they face currency risk, as do businesses that operate internationally.

Question 36

Define unsystematic (specific) risks

Answer 36

E.g. business, industry and management risks, i.e. risks associated with a particular business. Therefore, such risk can be reduced through diversifying the assets held.

Diversification San be achieved via investing in different companies, industries and countries

Question 37

Define business risk

Answer 37

Internal risks to a business, and associated with a company’s earnings and dividends.

Other factors include product design, raw material costs, labour relations, etc.

Question 38

Define industry risk

Answer 38

Industry risks are associated with the industry as a whole in which the business is operating. Factors include industry-related strikes, changes in consumer tastes, new regulations, etc

Question 39

Define management risk

Answer 39

Management risks reflect the importance of the calibre of management to a business, and the confidence it holds with the management team to deliver the company’s results

The risks associated with ineffective, destructive or underperforming management, which hurts shareholders and the company or fund being managed. For example, the Enron scandal

Question 40

Define the difference between direct and indirect investment

Answer 40

Direct investment is when personal investors possess financial assets by personally selecting, investing and registering funds in their own name, e.g. by buying property

Indirect investment is when personal investors possess financial assets via the use of experts, on behalf of the investor, e.g. using a stockbroker to buy shares

Question 41

Define direct investment

Answer 41

When personal investors possess financial assets by personally selecting, investing and registering funds in their own name, e.g. by buying property

Question 42

Define indirect investment

Answer 42

When personal investors possess financial assets via the use of experts, on behalf of the investor, e.g. using a stockbroker to buy shares

Question 43

Define real investments

Answer 43

Assets that can be seen, touched and personally enjoyed. They are physical, tangible assets, for example:

Immovable property - Either owner owned or non owner occupied (rented to provide income) can provide capital gains

Chattels - aka collectibles, e.g. antiques, wines, stamps and works of art. No income is generated, but the owner usually hopes to make a capital gain in disposal of the asset. Chattels can also be purchased to give pleasure

Question 44

Define immovable properly, and briefly describe the risks that investment in property carries

Answer 44

Either owner owned or non owner occupied (rented to provide income) can provide capital gains. Risks include:

Negative equity (value of property is worth less than that owed)

Fire/flood/damage, therefore high insurance costs

Cannot be converted to cash quickly

Professional advice and expertise will be required, which can be costly

Question 45

Define chattels

Answer 45

aka collectibles, e.g. antiques, wines, stamps and works of art. No income is generated, but the owner usually hopes to make a capital gain in disposal of the asset. Chattels can also be purchased to give pleasure. Risks associated with chattels include:

Special storage conditions may be required

Risks of fire/theft/flood

Valuation may be difficult

Market is less regulated

Possibility of forgery

Question 46

Define the difference between real investments and financial investments

Answer 46

Real investments are assets that can be seen, touched and personally enjoyed. They are physical, tangible assets

Financial assets are those represented by a piece of paper, ‘paper asset’. Financial investments have many forms and include bank accounts, shares, bonds, life assurances, etc

Question 47

Define financial investments

Answer 47

Those investments that are represented by a piece of paper, ‘paper asset’. Financial investments have many forms and include bank accounts, shares, bonds, life assurances, etc

Question 48

Define the various types of investor

Answer 48

Personal sector (private individuals and unincorporated business)

Companies

Public corporations, central government and local authorities

Institutional investors (insurance companies, pension funds, units trusts and investment banks)

Other investing institutions (charities, clubs and associations)