What Is Time Value of Money?

Understanding Time Value of Money

First Published: ADawnJournal.com June 23, 2010

Everyone wants to know how much their money is going to be worth down the road. Not only that, knowing how much money you may have will help you save better and make more money. Over the course of this article, I will cover four important concepts. They are:

1.   Time Value

2.   Present Value

3.   Net Present Value

4.   Future Value

All of these concepts will center on the value of money. We all know that money is valuable, but what about the time value of it? What is it worth now, how much is it truly worth now, what is its future value? All of these need to be understood if you are going to get the most out of your money.

Time Value

The time value of money is the value that is given to the amount of interest earned by the money over a certain period of time. That means that if the money earns a few dollars interest, then its time value will be based on how much value will be associated with the money and the interest. Here is a simple example to help show what we mean:

Let’s say you have 100 dollars right now and you put it away in an investment that earns you 10 percent over the next year. That means that your original 100 dollars is going to be worth 110 dollars in about a year. So, 100 dollars paid out now, or the 110 dollars paid out in one year will have the same value to the recipient who assumes the interest. However, using the time value of money, we know that the future value of the money is going to be 110 dollars. What makes this important is it allows a person to determine their future annual incomes. That way, annual incomes are discounted and added together to create a lump-sum that is the present value of a total income stream.

Present Value

The present value of money is the value of money on a given date for a future payment, discounted to reflect the time value of money and other factors. In economics, present value calculations are widely used, as well as in business.

If you are given the choice between getting $100 now, or $100 in one year, you will probably take the $100 now because that gives you money immediately. This is where Time Preference comes in. For example, if the $100 is worth $70 in one year, then the present value of the $100 one year in the future is $70. When you have money you have two options, you can save it or spend it. The benefit from saving money is that later on it will incur interest and that will give you more money down the road.

When money is evaluated for its present value in the future, it is called capitalization. So, let’s look at an example.

If you have the choice between $100 today and $100 in one year, you will probably choose the money now but if the money in a year earns 10 percent interest, then you can have $110 in one year, more than you would get now. The present value of the money at the future date is going to be $110.

Net Present Value

The net present value of a time series of money, both incoming and outgoing, is defined by the present values of the individual cash flows. Net Present Value is a central tool in discounted cash-flow and is used when determining the time value of money for long-term projects, such as budgeting within a company. By measuring the excess or shortfall of cash flows, in present terms, it is possible for companies to make good financial decisions.

Companies will use Net Present Value to determine if an investment or project is going to add value to the company. By using the calculations for Net Present Value, it is possible to determine the NPV and therefore, the value for the company as follows:

·   If the NPV is greater than zero, the investment would add money to the company and therefore the project should be accepted.

·   If the NPV is less than zero, then the investment will take value away from the firm and the project should be rejected.

·   If the NPV is equal to zero, then the investment will neither take money nor give money to the company. This means that decisions to accept or reject the project, should be based on other factors.

Future Value

The future value of money is how much a given sum of money will be worth at a specific time given the interest rate and the rate of return. The value does not include things like corrections for inflation.

Here is a brief example to illustrate future value of money. If you are given $100 today, it is worth $100, however in five years it will not be worth $100 because of the changing value of money. You can put the money into the bank and it will either grow or fall in value depending on interest. In addition, if you buy something today for $100, you may not be able to buy that same item for $100 because of inflation increasing the purchase price. Inflation can grow by about half a percent to one percent per year, and that will mean that the item will cost as much as five dollars more in five years.  As a result, economists will evaluate the true value of the money over a given period of time based on future value calculations. Companies and economists will look at the real interest rate to determine the purchasing power change over a period of time.

What Is An ETF (Exchange Traded Funds)?

Exchange-Traded Funds (ETF)

First Published: ADawnJournal.com March 28, 2010

What Is An ETF?

An ETF is a type of investment product that trades on an exchange like a stock. However, unlike a stock an ETF is not made of a single entity. An ETF is made of a group of investments. These groups can be a group of stock, bonds, natural resources, commodities, precious metals, etc. In most cases, an ETF follows an Index, as an Index is already made of a group of stock (or other investment products).

Advantages of ETFs

Lower Cost – The ongoing cost of holding ETFs (called Management Expenses Ratio or MER) is lower than mutual funds or index funds. For example, An ETF MER can be in the range of 0.25% – 1.00%; a mutual fund or an index fund MER can run in the range of 1.00% – 3.50%.

Flexibility – ETFs offer more flexibility as they trade on the stock exchange and can be bought or sold throughout the day during regular trading hours. Mutual funds do not offer this option, as they can be transacted using the NAV (Net Asset Value) which comes out at the end of the day.

Diversification – As ETFs are made of a basket of varieties of investments, they provide broad diversification and convenience. It would be time consuming, a lot of hassle, and almost impossible to get the same level of diversification with anything else.

You See What You Get – A major advantage of holding ETFs is that at least you get the return of the underlying index the ETF is tracking. You know what you are getting and you see what you get. With mutual funds, it is totally different. In general, regular mutual funds are made of many individual stocks (or other types of investment products) and most of the time you will have a hard time seeing what you are getting.

Tax Advantage – Tax liabilities are created when trading occurs in the fund. Active fund managers are always buying and selling securities in regular mutual funds. When you sell your mutual funds, fund managers have to sell securities to provide you with cash for your sell. However, this is not the case when you sell your ETFs. When you sell your ETFs, trading can occur between other ETF units holders (in-kind trade) – triggering no capital gain. This means ETFs do not need frequent trading to pay an investor who wants to redeem his part. Less trading creates less tax liability and thus, minimal to none capital gains. However, ETFs do need to trade occasionally. This type of trading occurs when index changes (as they are tracking index).

Easier Asset Allocation – ETFs let you easily manage asset allocation as you are able to see your entire ETFs in one place (your trading account) and thus track and manage asset allocation easily.

Low Maintenance – ETFs allow you to hold a broad range of indexes with minimal supervision. Studies show that experienced ETF investors beat most professional fund managers with a fraction of time and effort spent.

Disadvantages of ETFs

Requires Investment Knowledge – Buying ETFs is not as easy as mutual funds. You need to have a trading account and need to be some sort of investment savvy to hold ETFs.

Brokerage Fees – Buying ETFs incur brokerage commission or trading fees – just like stock, you pay fees to buy and to see. This makes buying ETFs for smaller amounts not justifiable.

No Dollar-Cost-Averaging – Since ETFs incur fees each time and buy and sell, it’s not a good vehicle for dollar cost averaging.

Market Timing – Since ETFs are easy to trade, it may tempt investors to do market timing (buy and sell to chase returns) via frequent trading and thus incurring a lots of transaction fees. ETFs work best for long time investors.

How ETFs Choose Its Holdings or Products

ETFs mainly use two methods to pick its holdings. These are called: Market-capitalization /Cap-weighted indexing and fundamental indexing.

Market-capitalization /Cap-weighted indexing replicates a market as-is. In this methodology, bigger companies have greater influence. Most common indexes such as the S&P/TSX Composite and the S&P 500 use this method. In Canada iShares and in the U.S. Vanguard use this method to operate many equity ETFs.

Fundamental indexing picks stocks by looking at fundamentals (such as earnings, book value, sales, dividends etc), not by size. Fundamental indexing proponents argue that Market-capitalization /Cap-weighted indexing overvalues larger and undervalues smaller equities. So to get true value, stocks’ fundamentals, not sizes should be looked at.

There are other methodologies such as price-weighted indexing, equal- weighted indexing, etc. If you are looking for the best indexing, there is no clear answer. You need to do a little research to find the best one that suits your needs. If you are looking for the cheapest one, Market-capitalization /Cap-weighted ETFs are usually the winner.

How to Buy or Sell ETFs

Since ETFs trade on exchanges, you need a trading account (discount brokerage account) to buy ETFs; just the same way you would buy stocks. In Invest Now, I have mentioned how to open a trading account at an ease.

Are There Any ETFs In Canada?

Canada is the country that invented ETF. |The world’s first ETF traded on the Toronto Stock Exchange in March 1990. Here are some ETF providers in Canada:

iShares Canada – The oldest and largest ETF provider in Canada.

Horizons – Horizons offers AlphaPro and betaPro ETFs. Horizons AlphaPro is the only ETF family that is actively managed ETF in Canada. Horizons BetaPro offers leveraged and inverse leveraged ETFs to profit in both bull and bear markets.

Claymore ETFs – Claymore offers various innovative intelligent investment strategies ETFs. This is the only company that offers ETFs that can do DRIPs (dividend reinvestment plan) in Canada.

BMO Exchange Traded Funds – New player in the ETF markets and the only major Canadian financial group to offer ETFs.

TMXMoney has a section on Exchange Traded Funds and I strongly encourage you to visit it.

How to Build an ETF Portfolio

I recommend you read these two articles I wrote.

How to Build an Investment Portfolio

What Is Asset Allocation?

A Dawn Portfolio (I am still working on this project and will add a link once done)

Once you are finished reading, do some more research and do some more reading from various other sources to have a good grasp of ETF. And then, if you are confident enough, construct a suitable portfolio that fits your needs. If you are not comfortable figuring out on your own, seek help from professional financial advisors.

NB – Currently, I do not have any articles giving ETF ideas, examples of Indices ETFs track and so on. I will be writing more on these in the future.

How Risky Are ETFs?

No investments come without risk (except some fixed income products like money market instruments, T – Bills, etc). However, due to the fact that ETFs provide a broad diversification with a wide variety of investments, you may be able to reduce some risk.

Last Word

As I mentioned in Invest Now, investment is an art. As such, it requires discipline, hard work and consistency. Do not blindly follow any ETF model portfolios or tools just because it looks cool. You are different than anyone else – make an educated decision based on your time horizon, risk tolerance, financial goals, and your overall financial situation.

The Great Depression

Great Depression: The Worst in Recent History

First Published: ADawnJournal.com March 26, 2010

The worst depression in recent history, and one of the defining periods of the 20th century was The Great Depression. From 1929 to 1939, many of the world’s economies suffered high unemployment and greatly decreased GDPs, putting great hardship on citizens and restricting trade between countries.

The Great Depression is the longest and deepest depression of the 20th century and it is now used as the benchmark for how bad a recession or depression is.

In the United States, unemployment rose to 25 percent, while other countries saw their unemployment rise past 30 percent. Many cities and industries were hit very hard, and international trade fell by 66 percent around the world, greatly impacting people around the world.

As well, crop prices fell by 60 percent, causing many farmers to lose their homes as record amounts of foreclosures occurred. Other industries that suffered greatly included banking, mining and logging.

Causes of the Great Depression

There is no one cause to The Great Depression, but these five are considered to have all played a part in it.

1.   The crash of the stock market in 1929 occurred on October 29, and is considered the start of The Great Depression. This event had a major impact on the economy of the United States, and within two months of the initial crash, stockholders had lost over $40 billion, causing many to lose everything they owned.

2.   The failure of banks was widespread in the United States during The Great Depression. From 1929 to 1939, over 9,000 banks failed because the deposits of the banks were not insured and when banks failed, depositors lost everything. The banks that were still around stopped giving out loans out of worry of going under themselves. This put a lot of people in difficult positions as they lost what they had and could not get money anywhere.

3.   Since people now had less money during The Great Depression, many people stopped buying things they did not need. This caused a reduction in the amount of items being made around the country, which then caused companies to go out of business. Hence, the unemployment rate rose to a record of 25 percent, which only made things worse.

4.   Another cause of The Great Depression was the Smoot-Hawley Tariff, which was created in 1930 to protect American companies from failing. This tariff charged very high taxes for imports, which caused trade between the United States and other countries to fall drastically. As a result, rather than helping the economy, it hurt it even more and further made The Great Depression worse.

5.   To make matters worse, when the economy started failing, so to did crops in the Mississippi Valley during 1930. The crop failures reached such high numbers that many farmers lost their homes as the breadbasket of the world turned into a dust bowl. This is the reason that the 1930s are often called The Dirty Thirties.

How the Great Depression Ended

Countries around the world began to move out of The Great Depression at various times throughout the 1930s. Many countries began to recover around 1933, while the United States reached its full recovery around 1940, just before the country’s entry into World War Two.

One reason for the United States coming out of The Great Depression was the New Deal created by President Roosevelt, which accelerated the recovery of the country due to aggressive spending to help create jobs for the citizens of the country.

However, for the United States, the biggest reason for recovery was the outbreak of the Second World War. When World War Two was declared, economies around the world were stimulated due to the rearmament policies of Allied countries to prepare for war. This was done to such a degree that Britain eliminated unemployment by 1939 when war was officially declared.

When the United States entered the war in 1941, the unemployment rate fell to below 10 percent, and war spending doubled the growth rate of the American economy, thereby stopping The Great Depression for good.

The Great Depression was a watershed moment in the 20th century that ranks with World War One and World War Two as the darkest times in the history of the 20th century. The Great Depression also taught the economists and policy makers in the United States how to avoid a depression and how to keep the economy of the country going. Since 1940, there have been no new depressions in the United States, partly in thanks to what was learned during The Great Depression.

What Is Mortgage Insurance?

Insurance On Your Mortgage – What You Need To Know

First Published: ADawnJournal.com April 2, 2010

If you have a mortgage, then the chances are that you have mortgage insurance. The principle of mortgage insurance is pretty simple. It is usually included in the mortgage when you take it out, with the value of the insurance added to the principal and other fees, and paid into monthly as part of your usual monthly payment. As with any other insurance premium, the idea is that if certain conditions are met and you are unable to make your monthly payments as normal, the insurance will cover those payments. Among the conditions that are relevant to mortgage insurance are: death, illness, unemployment. Depending on your mortgage account, you may be covered in case of all of these and more, just these, some of these or none. It is worth being aware of exactly where you stand regarding insurance on your mortgage.

The most common and all-encompassing reason for claiming on insurance is death. With other reasons for claiming, there can be arguing over the matter of what constitutes long-term illness, a pre-existing condition, the balance of fault for an employee’s sacking or renegotiated contract and so forth. With death, however, things are generally quite final – or so you would think. Having mortgage insurance that covers you for the death of yourself or a joint account holder may seem to mark the end of the argument, should one of you die. But some insurance companies are reluctant to pay out, and will go to great lengths to frustrate a claim. It is worth being very careful with regard to how the insurance was sold to you, and what the conditions are regarding payouts.

If you have filled in a form to purchase mortgage insurance – as part of an overall deal or separately – it is highly important that you read the questions carefully and answer them truthfully. Even if the answer to a certain question might increase your premium, or negate any cover, it is important to do this before you start paying the premiums. You could well find yourself some way down the line bereaved, ill or unemployed and with a claim for insurance being denied by the company for a reason you would consider to be wholly inaccurate and unfair. It is fair to assume, however, that the insurers have written the policy very carefully to favour themselves.

If you have been to the doctor for a routine check up, the chances are that they have run a routine blood pressure test. So if you are asked on the form whether you have been tested for high blood pressure, you will need to say you have. This may go against the spirit of the truth, but saying “no” may be legally considered a lie, and invalidate any claim made on the insurance. For absolute clarity, it is important to get all the terms of the insurance agreement nailed down before taking out any insurance – if it is heavily weighted against you, you will need to insure independently under the terms of an agreement that allows you to be covered fairly.

Should We Give Credit Cards to Kids?

Credit Cards and Kids

First Published: ADawnJournal.com April 3, 2010

We are living in the age of the Internet and high-tech electronic payment systems – an age in which you don’t need to carry physical money to pay for expenses. Denying the use of credit cards for kids would be like denying them living in the 21st century. These days, credit cards have become a common daily necessity like cell phones and drivers’ licenses. Credit card companies know that teenagers are a good segment of their target market and they are campaigning fiercely to grab their market share. Leaving kids unaware of credit cards would make them fall into the credit card debt trap and will make their whole life miserable in later years. Teaching kids how to handle credit cards and stay debt-free is an important part of being a parent and these lessons should start while they are still at home and at an early age. Today, I will look at the many different aspects of credit cards and kids.

Do Kids Need Credit Cards?

Whether parents like it or not, kids will be exposed to credit card offers these days more than ever. Mail-in offers, credit card companies trying to reach out to kids through various marketing and promotional techniques, and the plastic culture society (using plastic is considered cool) we are living in today – will make it impossible to deny let our kids the use of credit cards. If parents don’t allow them to use it, they will get their hands on it without parents’ knowledge; and credit card companies wait to seize these opportunities so they can prey on kids when kids are ready to try plastic without their parents’ knowledge.

That’s why parents should take the early initiative to break financial illiteracy and start giving kids financial lessons while they are still at home. Early education prevents financial disaster and costly mistakes at a later age. If kids know all the ins and outs of credit cards and start using them responsibly under guidance, they will be able to handle credit cards responsibly and in the long run will be able to avoid credit card debt and will score good credit ratings.

Benefits of Giving Kids Credit Cards

·   Building Credit: Although a credit card is not the most important factor in building good credit, it can definitely be a good tool to help establish good credit. By using credit cards responsibly and paying bills on time, kids will be able to start building a solid financial backbone.

·   Spending Plans: The word “Budget” may be a difficult one for kids to grasp. Create Spending Plans for them and teach the difference between Wants and Needs. Impulse buying can lead them into financial turmoil. Teach them how to spend money wisely on things they need and monitor their credit card bills carefully to make sure they are on track. Teach them the pitfalls of high balances and late payments and guide them to avoid these always.

·   Financial Responsibility: Teach kids about financial services and products along with credit cards as personal finance lessons are not given at educational institutions. Early personal finance education will instill values and responsibilities in kids and it is likely that they will analyze various financial steps they take and will avoid debt, paying interest, and actions to ruin their financial future.

What You Need To Do Before Giving Kids Credit Cards

Let’s look at some scenarios you need to consider before giving them a credit card.

·   Start Talking: Start talking to your kids about the pros and cons and other aspects of credit cards. Tell them the good things about credit cards such as convenience, credit score, better job prospects with a better credit score, lower insurance rates and so on. Tell them the bad things such as interest, late payments, misuse of the card, how it can ruin their credit rating and so on. Tell them about minimum payments, interest charges, why it is wise to pay the balance in full, the effects of late payments, the effects of spending beyond limits and so on.

·   Does He/She Have a Bank Account? Make sure he/she knows how to deal with a bank account and ATM cards, and teach them banking basics before handing them a credit card.

·   Is Your Kid Ready? You need to make this judgment call to determine if your kid is ready to handle credit cards. Is he/she responsible and able to handle money and credit cards? Does he/she know when to buy and when not to buy? What to buy and what not to buy? Does he/she have a job to pay credit card bills? If not, how it will be paid? Will he/she be paying off the balance in full every month? Does he/she realize that interest will be charged if the balance is not paid in full? If you think he/she is not ready yet, continue giving them lessons until he/she is ready.

·   Lay Out a Roadmap: Tell them exactly what things are allowed with their credit cards and what aren’t. This will avoid confusion later on. Tell them what may happen if they fail to follow these guidelines.

What Kind of Credit Cards Should You Give Kids?

There are different opinions on this matter. Some financial experts suggest that you should start with a debit card first and then switch to a credit card. Some experts argue that a prepaid credit card is the best vehicle to start teaching kids about credit cards. Some experts think parents should add kids to their own card as an authorized user so they can monitor how they are doing. However, my own point of view is little different and I think the best type of credit to start with for kids is a credit card with a lower limit. I will tell you why I think this way and what the problems are with the other views I mentioned above.

First of all, a debit card is a debit card. It comes nowhere near close to giving your kids the experience and lessons you expect to give by using a credit card. Before having their first credit card, they should already have a bank account, an ATM card or debit card and this should be enough to give them the experience of how a debit card works. So a debit card is not an alternative to a credit card and kids should have a bank account and a debit card whether they have a credit card or not.

Secondly, prepaid credit cards may sound like credit cards but they aren’t giving kids the real-life experience of a real credit card. These prepaid credit cards have no monthly bills, interest rates, or late fees, as they are paid before and you can use only up to the amount you loaded onto your account beforehand. So it is missing the real, relevant experience of a credit card.

Thirdly, parents should never add kids to their own credit card account. Parents’ credit card accounts will always have much higher limits than you want your kids to access and it will not give them the sense that they need to be financially responsible, as they will know that this is not their own credit card and they don’t need to act responsibly.

A credit card with a lower limit, $200 to $300 to start with, is the best credit card teaching vehicle for kids to start learning the uses of credit cards and start the journey towards becoming financially responsible.

What You Need To Do After Giving Kids Credit Cards

Monitor the transactions on the credit card account regularly. Make sure they are not buying above the limit or buying the things you asked to avoid. Make sure they are paying bills on time. Reinforce the roadmap you laid out before for using the credit card and make sure they are following it. Discuss credit card mistakes you have made or someone else has made in the past and tell them to use them wisely to stay out of credit card debt. Show them good resources on the Internet to learn more about personal finances and how staying financially healthy can pay off throughout the course of their lives. With all the good intentions, if they falter and are unable to handle credit cards and make small mistakes, help them to bailout – but give them the message that this is not going to be a repetitive act and they will have to pay off the bills by working off their own money.

At What Age Kids Should Get Credit Cards?

It all depends. If your kid is ready to handle it, a credit card can be given to 12 – 15-year old kids. However, don’t continue credit card ties with your kids after 20 + years of age. At this point, this should be the end of their college years and they should be responsible enough to handle their own credit. Let them know at least a year ahead that this will be their last year to have credit cards under your guidance and monitoring.

Last Word

Kids do what they see. Teaching alone will not be sufficient to teach kids about credit cards. Kids will watch their parents and copy their financial behavioural patterns. It is important for parents to be financial role models and set up good examples for kids to follow towards achieving financial success. Bottom line, early credit card education depends on how parents proceed and handle their kids’ credit card journey, including misuses of credit cards. Kids can become more responsible or less responsible depending on their parents’ actions.