Test - Chapter 14 Flashcards
What is the difference between savings and investing?
Saving and investing are both essential components of personal finance, but they serve different purposes. Let’s break down the key differences:
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Saving:
- Purpose: Saving involves setting aside money for short-term goals or needs. It’s like putting your money in a piggy bank, but instead of an actual piggy bank, you can use a savings account or a certificate of deposit (CD).
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Safety and Accessibility:
- Safety: Savings are generally low-risk. Your money is safe, but the interest rates received are also low.
- Accessibility: You can access your savings easily without penalties.
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Examples:
- Setting aside a portion of your allowance or paycheck into a savings account each month to save for a specific goal (e.g., a new laptop).
- Building an emergency fund for unexpected expenses (e.g., car repairs or medical bills).
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Investing:
- Purpose: Investing is usually done for longer-term goals, such as retirement or children’s college funds. The primary goal is to grow your money over time.
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Risk and Potential Returns:
- Risk: Investing comes with risk, as market performance can lead to gains or losses.
- Returns: The potential for higher returns is greater with investing compared to saving.
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Accounts and Assets:
- Accounts: Investing is often done through retirement accounts (e.g., 401(k) or IRA) or brokerage accounts.
- Assets: Investments include stocks, bonds, mutual funds, ETFs, and even physical assets like real estate.
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Example:
- Investing in a diversified portfolio of stocks and bonds to build wealth over time.
In summary, saving is for short-term needs, emphasizing safety and accessibility, while investing focuses on long-term growth potential, even though it comes with higher risk. Remember that both saving and investing play crucial roles in achieving financial stability and security
What is a savings plan? Emergency needs, short and long-term goals, security and future needs.
A savings plan is essentially a strategic approach to setting aside money for future needs, whether they are immediate, like an emergency fund, or long-term, such as retirement. Here’s a breakdown of what a savings plan might cover:
- Emergency Needs: This is money set aside for unexpected expenses, such as medical bills, car repairs, or job loss. It’s generally recommended to have enough to cover 3-6 months of living expenses.
- Short-Term Goals: These could include saving for a vacation, a down payment on a car, or any large purchase that you plan to make within the next few years.
- Long-Term Goals: These are savings for your distant future, which might include a child’s education, purchasing a home, or retirement.
- Security and Future Needs: This aspect of a savings plan is about ensuring you have a financial cushion to protect against life’s uncertainties and to provide for your needs as you age.
Creating a savings plan involves:
1. Identifying your financial goals.
2. Determining the amount you need to save for each goal.
3. Setting a timeline for when you need the funds.
4. Deciding where to save your money, such as in a savings account, a fixed deposit, or an investment account.
5. Automating your savings to ensure consistent contributions towards your goals.
It’s important to review and adjust your savings plan regularly to reflect any changes in your financial situation or goals. security
Principal (original amount of money deposited/invested)
The principal refers to the original amount of money deposited or invested. It is the initial sum of money that serves as the basis for calculating interest, returns, or other financial outcomes. In financial contexts, the principal is a fundamental concept, especially in areas such as loans, investments, and savings accounts.
For example, if you invest $1000 in a savings account with an annual interest rate of 5%, the initial $1000 is the principal. Over time, the interest earned will be calculated based on this principal amount.
Mathematically, the relationship between principal, interest, and time can be expressed using the formula for simple interest:
Simple Interest = Principal * Rate * Time
Where:
- Principal is the initial amount.
- Rate is the interest rate (expressed as a percentage).
- Time is the duration (usually in years).
Remember that this formula assumes simple interest, which means the interest is not compounded. For more complex scenarios, such as compound interest, additional formulas and considerations come into play.
Calculate simple interest, compound interest and rate of return (also called yield)
Let’s break down the concepts of simple interest, compound interest, and rate of return (yield):
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Simple Interest:
- Definition: Simple interest is the annual percentage of a loan amount that must be paid to the lender in addition to the principal amount of the loan.
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Formula:
Simple Interest = Prn
where:- (P) is the principal amount (initial investment or loan amount).
- (r) is the annual interest rate (expressed as a decimal).
- (n) is the term of the loan (in years).
- Example: Suppose you invest $10,000 at an annual interest rate of 5% for 3 years. The simple interest earned would be:Simple Interest = 10,000 * 0.05 * 3 = 1,500
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Compound Interest:
- Definition: Compound interest is based on the sum of the principal amount and the previous interest payments on it. It is calculated periodically (e.g., daily, monthly, annually).
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Formula:A = P * ( 1 + r / n ) ^ (nt)
where:- (A) is the final amount (including interest).
- (P) is the initial principal balance.
- (r) is the interest rate.
- (n) is the number of times interest is applied per time period.
- (t) is the number of time periods elapsed.
- Example: If you invest $5,000 at an annual interest rate of 6% compounded annually for 5 years:A = 5,000 * ( 1 + 0.06 / 1 ) ^ 1 * 5 = 6,633.82The compound interest earned would be
6,633.82 - 5,000 = 1,633.82.
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Rate of Return (Yield):
- Definition: Yield refers to how much income an investment generates, separate from the principal. It can be expressed as a percentage.
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Calculation:
- Yield is forward-looking and considers income (e.g., interest, dividends) received during a specific period.
- Return is backward-looking and includes total interest, dividends, and capital gains (change in value) over a specific timeframe.
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Example:
- You purchase 100 shares of stock XYZ for $50 per share ($5,000 total).
- XYZ pays a quarterly dividend of 50 cents per share.
- Over a year, you receive $200 in dividend income.
- Your initial investment yielded 4% ( 200 / 5,000 * 100 ).
- If XYZ’s share price increased to $55 per share, your total return would be 14% ( 700 / 5,000 * 100 ).
Remember that simple interest is straightforward, while compound interest grows faster due to reinvesting interest. Yield focuses on income, and return considers both income and capital gains. Use yield and return together to evaluate an investment’s overall performance.
Canada Deposit Insurance Corporation (CDIC)
The Canada Deposit Insurance Corporation (CDIC) is a federal Crown corporation established by the Canadian government. It was created by Parliament in 1967 to provide deposit insurance and protect depositors’ money in case of a member financial institution’s failure.
Here’s a summary of how CDIC works:
- Coverage: CDIC insures eligible deposits up to $100,000 (including principal and interest) per depositor, per insured category, at each member institution.
- Insured Categories: There are several categories for which CDIC provides separate insurance coverage, including deposits held in one name, joint accounts, registered retirement savings plans (RRSPs), registered retirement income funds (RRIFs), tax-free savings accounts (TFSAs), and more.
- Member Institutions: CDIC coverage applies to deposits held at member Canadian banks and savings institutions.
Liquidity
Liquidity refers to the ease and efficiency with which an asset or security can be converted into ready cash without affecting its market price. It’s a measure of how quickly and easily assets can be sold or exchanged for cash to meet financial obligations. The most liquid asset is cash itself, as it can be used immediately to transact or settle debts.
There are two main types of liquidity:
1. Market Liquidity: This pertains to the extent to which a market allows assets to be bought and sold at stable, transparent prices. High market liquidity means there’s a high supply and demand for an asset, ensuring that it can be sold quickly at a fair value.
2. Accounting Liquidity: This measures a company’s ability to pay off its short-term obligations with its most liquid assets. Common measures of accounting liquidity include current, quick, and cash ratios.
Assets like savings accounts, stocks on major exchanges, and government bonds are considered liquid because they can be readily sold for cash. Conversely, assets like real estate and fine art are less liquid because they may take longer to sell and could require a discount to do so quickly.
Understanding liquidity is crucial for both individuals and businesses as it impacts financial flexibility and the ability to respond to immediate monetary needs or opportunities.
What are savings accounts, term deposits and GICs(cashable/non-cashable)? Explain some features of each.
Features of savings accounts, term deposits, and Guaranteed Investment Certificates (GICs):
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Savings Accounts:
- Definition: A savings account is a basic banking product where you can deposit money and earn interest. It’s designed for everyday use and provides liquidity, allowing you to withdraw funds whenever needed.
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Features:
- Withdrawal Anytime: You can access your money at any time without penalties.
- Interest Rates: The interest rates on savings accounts can change over time.
- Minimum Balance: Typically, there’s no minimum balance requirement.
- Risk: Low risk.
- Advantages: Suitable for emergency funds or funds you might need anytime.
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Disadvantages:
- Inflation Risk: The rate of return may not keep up with inflation.
- Lower Returns: Historically, returns on savings accounts are lower compared to other investments.
- Example: If you have cash you want readily available, a savings account is a good choice.
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Term Deposits (also known as Certificates of Deposit):
- Definition: Term deposits are low-risk investments where you agree to lock up your funds for a specific period. In return, the financial institution guarantees the return of your principal plus interest.
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Features:
- Fixed-Rate Investment: Offers fixed interest rates over a set term.
- Term Length: Usually between 30 days and 5 years.
- Withdrawal Restrictions: You can’t withdraw your money until the end of the term (or face penalties).
- Interest Rates: Generally higher for longer terms.
- Customizable: Available in flexible terms (up to 5 years) and can be held in registered plans (e.g., TFSA, RRSP).
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Advantages:
- Predictable Returns: You know the exact return at the end of the term.
- Peace of Mind: Fixed rates provide stability during market volatility.
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Disadvantages:
- Liquidity: Limited access to funds until maturity.
- Lower Liquidity than Savings Accounts: Term deposits offer less liquidity than savings accounts.
- Example: If you’re saving for a specific goal and want stability, consider a term deposit.
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Guaranteed Investment Certificates (GICs):
- Definition: GICs are similar to term deposits but are often offered by insurance companies and trust companies. They guarantee a fixed interest rate in exchange for lending your money for a specific period.
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Features:
- Term Length: Ranges from 3 months to 10 years.
- Withdrawal Restrictions: Funds are locked for the entire term.
- Interest Rates: Often higher for longer terms.
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Advantages:
- Higher Returns: Offers better returns than savings accounts.
- Low Risk: Minimal risk.
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Disadvantages:
- Lack of Liquidity: No regular deposits allowed; money is invested for the entire term.
- Inflation Risk: Returns may not keep up with rising prices.
- Example: If you can afford to lock your money for a couple of years, a GIC may provide better returns than a savings account.
In summary, savings accounts are for immediate access, term deposits offer stability, and GICs provide higher returns with limited liquidity. Choose based on your financial goals and risk tolerance.
What are RRSPs, RESPs, TFSAs? Explain some features of each.
Features of RRSPs (Registered Retirement Savings Plans), TFSAs (Tax-Free Savings Accounts), and RESPs (Registered Education Savings Plans):
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RRSP (Registered Retirement Savings Plan):
- Purpose: RRSPs are tax-sheltered registered accounts designed to save for retirement.
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Tax Benefits:
- Contributions are tax-deductible, reducing your taxable income.
- Investments grow tax-deferred until withdrawal.
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Annual Contribution Limit:
- Determined based on 18% of the previous year’s earned income (up to a maximum limit).
- Unused contribution room can be carried forward.
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Withdrawals:
- Taxable upon withdrawal.
- Must convert to a retirement income option (e.g., RRIF) by age 71.
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Special Features:
- Spousal RRSPs can reduce household taxable income.
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TFSA (Tax-Free Savings Account):
- Purpose: TFSAs allow tax-free growth of investments and easy access to your money.
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Tax Benefits:
- Gains from investments and savings are tax-free.
- No tax on withdrawals.
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Annual Contribution Limit:
- Set by the government each year.
- Unused contribution room carries forward indefinitely.
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Withdrawals:
- Tax-free.
- Withdrawal amount is added to contribution room the following year.
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Special Features:
- Wide array of investment options (stocks, bonds, ETFs, etc.).
- No requirement to close the account at a certain age.
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RESP (Registered Education Savings Plan):
- Purpose: RESPs are for saving for a child’s education.
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Tax Benefits:
- Tax-deferred growth of investments.
- Canada Education Savings Grant (CESG) matches 20% of contributions (up to a max per beneficiary).
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Annual Contribution Limit:
- No annual limit; lifetime limit of $50,000 per beneficiary.
- Unused contribution room can be carried forward.
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Withdrawals:
- Educational assistance payments (earnings and grants) are taxable to the beneficiary.
- Return of original contributions is tax-free.
Choose the account(s) that align with your financial goals and circumstances. Remember that each account serves a specific purpose, so consider your needs carefully.
Why do good investors diversify their investments?
Good investors diversify their investments for several important reasons:
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Risk Reduction:
- Diversification helps spread risk across different assets. By investing in a variety of assets (such as stocks, bonds, real estate, and commodities), an investor reduces the impact of poor performance in any single investment. If one asset class underperforms, others may compensate, leading to a more stable overall portfolio.
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Minimizing Volatility:
- Different asset classes have varying levels of volatility. By combining assets with low correlation (i.e., they don’t move in the same direction at the same time), an investor can reduce the overall portfolio’s volatility. For example, when stocks decline, bonds may rise, providing a buffer.
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Opportunity Capture:
- Diversification allows investors to participate in various market opportunities. Different sectors, industries, and geographic regions perform differently over time. By diversifying, investors position themselves to benefit from growth in different areas.
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Long-Term Growth:
- A diversified portfolio aims for consistent, long-term growth. While individual assets may experience short-term fluctuations, a well-diversified portfolio tends to appreciate over time. This is especially important for retirement planning.
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Liquidity and Accessibility:
- Diversification ensures that investors have access to different types of assets. Some investments may be more liquid (easily converted to cash) than others. Having a mix allows flexibility in meeting financial needs.
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Behavioural Benefits:
- Diversification helps prevent emotional decision-making. When one investment performs poorly, investors may panic and sell. A diversified portfolio encourages a more disciplined approach, reducing impulsive reactions.
Remember that diversification doesn’t guarantee profits or eliminate all risks, but it’s a prudent strategy to manage risk and enhance long-term returns.
What is a Canada Savings Bond? Maturity date and face value.
A Canada Savings Bond (CSB) was a financial product issued by the Canadian government from 1945 through 2017. Here are some key features:
- Maturity Date: CSBs were typically issued with a maturity period of 10 years. However, they could be cashed at any time before maturity.
- Face Value: CSBs were available in denominations of $100, $300, $500, $1,000, $5,000, and $10,000. The face value is the amount paid to the bondholder at maturity, assuming the bond is not cashed in early.
The interest rate for CSBs was guaranteed for the first year and then fluctuated with market conditions for the remaining term. They were considered a low-risk investment and were popular among Canadians for their stability and ease of purchase through payroll deduction plans or directly online.
Please note that the CSB program has been discontinued, and all bonds in the CSB Payroll Savings Plan reached maturity and were paid out by November 2021.
What are securities?
A security is a broad financial term that encompasses a wide range of investments. These investments include:
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Equity Securities:
- Definition: Equity securities represent partial ownership in a company or other entity. The most common type is public company stock. Shares of mutual funds and pure equity exchange-traded funds (ETFs) also fall under this category.
- Investor Objective: Equity securities investors aim to generate capital gains as the value of their ownership stake increases over time.
- Risk and Return: Generally considered higher-risk investments than debt securities, but they also typically offer higher potential returns.
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Debt Securities:
- Definition: Debt securities function like loans. Investors lend principal to another party (such as a corporation or government) in exchange for predetermined interest payments at regular intervals. Once the debt security matures, the borrower must repay the principal in full.
- Examples: Corporate bonds, government bonds, and other fixed-income instruments.
- Investor Objective: Seeking interest payments and stability.
- Risk and Return: Lower risk compared to equity securities, but typically lower potential returns.
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Hybrid Securities:
- Definition: Hybrid securities combine aspects of both debt and equity. They offer features of both types.
- Examples: Convertible bonds (which can be converted into equity), preferred shares (with characteristics of both debt and equity), and other structured financial products.
- Investor Objective: Varies based on the specific hybrid security.
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Derivative Securities:
- Definition: Derivatives derive their value from another asset (such as a stock or commodity). They are typically contracts specifying terms for an exchange of assets under specific conditions.
- Examples: Futures contracts, options contracts, and swaps.
- Investor Objective: Used for risk mitigation or speculation on price changes in an underlying asset.
In summary, securities include a wide array of investments—stocks, bonds, notes, limited partnership interests, and more. They play a crucial role in raising capital and are regulated by organizations like the Securities and Exchange Commission (SEC). Remember that tangible assets like cars, houses, or gold bars are not classified as securities.
Who is a shareholder?
A shareholder is any person, company, or institution that owns shares in a company’s stock or holds shares in a mutual fund. Here are some key points about shareholders:
- Ownership: Shareholders essentially own a portion of the company. Owning even a single share makes someone a shareholder.
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Rights and Responsibilities:
- Voting Rights: Shareholders have the right to vote on certain matters related to the company, such as electing board members or approving dividends.
- Financial Benefits: Shareholders may receive dividends (financial profits distributed by the company) and can benefit from increased stock valuations.
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Types of Shareholders:
- Common Shareholders: These own a company’s common stock and have voting rights. They can influence company decisions and may file class-action lawsuits if needed.
- Preferred Shareholders: These own preferred stock but have no voting rights. Instead, they receive a fixed annual dividend before common shareholders.
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Majority vs. Minority Shareholders:
- A majority shareholder controls more than 50% of a company’s outstanding shares and wields significant power.
- Minority shareholders hold less than 50% of the stock and have less influence.
- Liability: Unlike sole proprietors or partners, corporate shareholders are not personally liable for the company’s debts.
- Liquidation: In case of company liquidation, shareholders may receive proceeds after creditors have been paid.
Remember that being a shareholder involves both financial benefits and responsibilities within the company.
What is the difference between bull and bear markets?
The difference between bull and bear markets is primarily in the direction of market prices and the general sentiment of investors:
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Bull Market:
- Direction: Characterized by rising stock market prices.
- Investor Sentiment: Generally reflects optimism and confidence in the economy.
- Duration: Tends to last longer than bear markets, with prices rising over an extended period.
- Behaviour: Investors are more likely to invest, hoping to capitalize on the upward trend.
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Bear Market:
- Direction: Defined by a decline in stock market prices, typically by at least 20% from recent highs.
- Investor Sentiment: Reflects pessimism and uncertainty about the economy.
- Duration: Usually shorter than bull markets, but can vary in length.
- Behaviour: Investors may sell off their investments due to fear of further losses, which can exacerbate the downturn.
In essence, a bull market signifies a period of economic growth and positive investor sentiment, while a bear market indicates economic slowdown and negative investor sentiment. Understanding these market conditions can help investors make informed decisions about their investment strategies.
What is the difference between common stock and preferred stock?
The difference between common stock and preferred stock primarily lies in the rights and benefits provided to shareholders:
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Voting Rights:
- Common Stock: Holders of common stock typically have the right to vote at shareholders’ meetings, usually at one vote per share owned.
- Preferred Stock: Generally does not provide voting rights to its holders.
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Dividends:
- Common Stock: Dividends are not guaranteed and can vary based on the company’s performance and decisions by the board of directors.
- Preferred Stock: Usually offers fixed dividends and holders have priority over common stockholders when dividends are distributed.
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Liquidation Preference:
- Common Stock: In the event of a company’s liquidation, common stockholders are paid after creditors, bondholders, and preferred stockholders.
- Preferred Stock: Holders have a higher claim on assets and earnings than common stockholders and are paid before them in liquidations.
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Risk and Return:
- Common Stock: Generally carries more risk but also the potential for higher returns through capital gains if the company’s value increases.
- Preferred Stock: Considered less risky than common stock due to fixed dividends and priority in liquidation, but typically offers less potential for capital appreciation.
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Income Stability:
- Common Stock: Less predictable income due to variable dividends.
- Preferred Stock: More stable income stream from fixed dividend payments.
In summary, preferred stock combines features of both equity and debt, offering fixed dividends and greater security during liquidation but without voting rights. Common stock offers potential for higher returns and voting rights but comes with greater risk and less predictable income.
What are blue chip companies?
Blue chip companies are nationally or internationally recognized, well-established, and financially sound companies that are publicly traded. They are known for selling high-quality, widely accepted products and services. Blue chip companies have reputable brands that have been built and maintained over many years, and they operate profitably despite adverse economic conditions, contributing to their long records of stable and reliable growth.
Here are some key characteristics of blue chip companies:
- Market Capitalization: Often in the billions, indicating a large company size.
- Stock Listings: Usually listed on major stock exchanges like the NYSE or Nasdaq.
- Dividends: Typically have a history of paying stable or growing dividends.
- Reputation: Known for their quality and reliability, often being market leaders or among the top companies in their sector.
- Investor Preference: Many conservative investors prefer blue chip stocks for capital preservation and consistent dividend payments.
Blue chip stocks are seen as relatively safe investments with a proven track record of success and stable growth. However, it’s important to note that no investment is entirely risk-free, and even blue chip companies can experience volatility.
