Case Study Investments Case Study Investments how should Christian invest his money?
Getting Started 16-year-old Christian Späth has saved a total of 5,000 Euros from the money he earned at his last two summer jobs and from the money friends and relatives gave him at his confirmation. Christian wants to use the money to pay for his driving licence in two years. He estimates that the costs will be no more than 2,500 Euros. His grandparents have promised that they will give their five-year-old car to Christian once he has his licence. Christian also wants to replace his old computer with a new laptop in a year, since his old computer runs increasingly slow when working with new programs. The laptop will probably cost about 500 Euros. Kai Späth, Christian s father, sees that there is quite a bit of money in his son s checking account. He informs his son that a checking account is not ideal for saving money. His father suggests he look for alternative investments that would yield a higher profit on the Internet and at the local banks. After all, the money is Christian s own savings. Exercise 1 What would you recommend Christian? You may decide to distribute the amount across different forms of investment. Be sure to also take the assessment criteria for investments into account when making your decision. You may choose from the following investment options: Savings book Money market account Fixed deposit Shares Mutual funds Before you work out your recommendation for Christian, you should consider the question of inflation and what its effects on Christian s investments might be. 1
Inflation The inflation rate reflects the price increase of goods (i. e. cars, computers, TVs, food, etc.) and services (i. e. the cost of public transportation, a haircut, a cell phone, a movie, etc.). These different goods and services are consolidated into a basket of commodities. The basket of commodities represents the average expenditure of a citizen of the Federal Republic of Germany. All together, there are 700 goods and services in the basket of commodities. If the value of the basket of commodities increases by 1 % in one year, the inflation rate is also 1 %. In order to calculate the inflation rate, the price increase from the previous month to the current month is measured. For example, the price of the basket of commodities in August 2010 as compared to August 2009 increased by 1 %, which means the inflation rate is also 1 %. If prices decrease within a span of time, this is called deflation. The last deflation in Germany occurred from July to September 2009. The main reason for this was the sharp decline in commodity prices, which also made many goods and services cheaper. In contrast, the sharp increase in commodity prices from the beginning of 2006 to the middle of 2008 was responsible for an increased inflation rate (figure 1). Among other things, this can be seen in the change in price for a liter of premium gasoline (figure 2). The rate of inflation must be taken into consideration when investing, because if the yield from his investment is higher than the inflation rate, Christian can buy more goods and services in the future for his money as if he would spend his savings immediately. That is why he should choose investments that promise a higher yield than the inflation rate. Figure 1: Trend inflation rate from January 1992 to December 2010 7,0 6,0 5,0 Inflation rate in % 4,0 3,0 2,0 1,0 0,0 Rising commodity prices Falling commodity prices -1,0 Jan 1992-01 1992 Jan 1993-01 1993 Jan 1994-01 1994 Jan 1995-01 1995 Jan 1996-01 1996 Jan 1997-01 1997 1998-01 Jan 1998 Jan 1999-01 1999 2000-01 Jan 2000 2001-01 Jan 2001 2002-01 Jan 2002 2003-01 Jan 2003 2004-01 Jan 2004 2005-01 Jan 2005 2006-01 Jan 2006 2007-01 Jan 2007 2008-01 Jan 2008 Jan 2009-01 2009 2010-01 Jan 2010 Source: Statistisches Bundesamt Deutschland, own display 2
Figure 2: Price trend premium gasoline (price per liter) 1,50 EUR 1,40 EUR 1,30 EUR 1,20 EUR 1,10 EUR 1,00 EUR 0,90 EUR 0,80 EUR 0,70 EUR 0,60 EUR 0,50 EUR 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Sources: Mineralölwirtschaftsverband e. V. und Statistisches Bundesamt Deutschland (www.mwv.de und www.destatis.de) The cost of a driving licence was roughly 1,360 Euros in 1991 (see figure 3). Almost 20 years later, a driving licence costs about 2,000 Euros. That is about 640 Euros or 47 % more. The average inflation rate for a driving licence over this period of time was about 1.95 %. This means that if Christian wants to get his driving licence in two years, he will have to pay 3.93 % more. Currently a driving licence costs around 2,000 Euros, but, in 2012, Christian will have to spend about 2,079 Euros. Figure 3: Price trend for a driving licence 2.100 EUR 2.000 EUR 1.900 EUR 1.800 EUR 1.700 EUR 1.600 EUR 1.500 EUR 1.400 EUR 1.300 EUR 1.200 EUR 1.100 EUR 00 EUR 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Sources: Statistisches Bundesamt Deutschland and www.destatis.de (Conditions: The price was estimated to be 1.800 Euros in 2005. The basic fee for lessons in theory, the costs of the licence, and costs of the test are not taken into account.) 3
Savings book Christian already knows the small and convenient savings book in paperback format from the Sparkasse s savings campaign and the World Savings Day. While in primary school, Christian had one of these books. The savings book is a saving account with a bank. As the name already suggests, it is used to save money. A saving book allows Christian to deposit and withdraw money, although it does not allow him to pay regular bills for magazines, cell phone, etc. As a reward he sets interest on his savings at the end of the year. The more he has save, the more interest he gets. The interest rate depends, among other things, from the savings amount. The higher the savings amount, the higher the interest rate. Between the banks the interest rates can vary considerably. Current conditions (status 11/31/2010) Volksbank Neckarraum: < 5,000 Euros 0 % > 5,000 Euros 1.25 % Kreissparkasse Stuttgart: < 2,500 Euros 0.85 % > 2,500 Euros 1.25 % Direktbank AG: < 10,000 Euros 1.15 % > 10,000 Euros 1.40 % 4
Money market account A money market account is a very flexible account: Christian can deposit and withdraw money at any time. The interest rate is higher than in a checking account. But, unlike a checking account, a money market account is intended for daily transactions. The bank can adjust the interest rate at any time. Often, they offer their customers a very high interest rate on money market accounts. Banks can thus easily win new customers and thereafter offer them additional financial products. Their approach is similar to that of cellular providers which constantly offer their clients further tariff options once they have signed a contract with them or that of insurance companies which attract clients by offering cheap vehicle liability and comprehensive insurance policies so that they can later sell additional insurance products. Especially direct banks, which do not maintain expensive bank branches, constantly outdo each other with new offers. But for that, Christian would have to do everything via the Internet or by mail, whereas he can get comprehensive advice from a regional banks branch. 5
Figure 4: Interest rate trend money market from May 1995 to December 2010 up to an investment of 5,000 Euros 4,00 3,50 3,00 Interest rate in % 2,50 2,00 1,50 1,00 0,50 0,00 Mai 1995 Mai 1996 Mai 1997 Mai 1998 Mai 1999 Mai 2000 Mai 2001 Mai 2002 Mai 2003 Mai 2004 Mai 2005 Mai 2006 Mai 2007 Mai 2008 Mai 2009 Mai 2010 Source: FMH Finanzberatung (www.fmh-finanzberatung.de) Current conditions (status 11/31/2010) Volksbank Neckarraum: < 250,000 Euros 0.90 % > 250,000 Euros 0.60 % Kreissparkasse Stuttgart: < 250,000 Euros 0.90 % > 250,000 Euros 0.40 % Direktbank AG: < 10,000 Euros 1.50 % > 10,000 Euros 1.10 % 6
Fixed Deposit With a fixed deposit investment, Christian makes his money available to the bank for a specific period of time, from anywhere between a month to five years. During this period, he receives a fixed interest rate on the money invested, but he cannot access his money during this time. As compensation for not being able to withdraw money during the deposit period, Christian receives a relatively higher annual interest rate from his bank as compared to that on a savings book. Current conditions (status 11/31/2010) Volksbank Neckarraum: 2 years: 1.60 % 3 years: 1.75 % 4 years: 2.00 % 5 years: 2.20 % Kreissparkasse Stuttgart: 2 years: 1.50 % 3 years: 1.70 % 4 years: 1.90 % 5 years: 2.10 % Direktbank AG: 2 years: 1.80 % 3 years: 2.00 % 4 years: 2.20 % 5 years: 2.45 % 7
Shares If Christian were to buy shares, he would become a shareholder in a corporation. If the corporation earns a profit, i. e. if its revenues are greater than its expenditure, Christian receives a share of the profits referred to as a dividend. As a shareholder, he can also benefit from rising stock prices. One of the conditions for stock prices to rise is positive corporate development as well as positive macroeconomic conditions. Stock prices, however, can also fall and are usually subject to severe fluctuations. Consequently, Christian could also lose money if he were to invest in shares. The following examples illustrate some of the reasons for changes in stock prices: Examples of positive corporate development Increasing sales and profits with a revolutionary business model (e. g. Amazon the world s largest online retailer, ebay the world s largest online auction site, H&M a supplier of contemporary fashion at affordable prices with more than 2,000 stores worldwide) Promising acquisitions or strategies (e. g. Volkswagen the use of a single platform for all its car brands Audi, Seat, Skoda, Volkswagen, etc.) Successful introduction of new products or services (e. g. Apple Mac, ipod, iphone, ipad, itunes) Examples of positive macroeconomic conditions Low interest rates Strong or acceptable levels of economic growth Business-friendly policies (e. g. tax cuts) 8
Examples of negative corporate development Declining sales and profits due to an antiquated business model (e. g. Karstadt a department store holding group with a large variety of products suffering from increasing competition from highly specialised companies such as Amazon, ebay and H&M, etc.) Takeovers that have not met the shareholders expectations (e. g. BMW s acquisition and (subsequent) sale of Rover or Daimler s acquisition and (subsequent) sale of Chrysler) Product flops (e. g. individual series of automobile manufacturers) Examples of negative macroeconomic conditions Rising interest rates Low or zero economic growth or a recession (contracting economy) Business-unfriendly policies (e. g. tax increases) Exceptional circumstances (wars, terrorist attacks) Varied share price behavior of well known market leaders The share price movements of different corporations can vary significantly from each other, even when they are all large dominant companies. For example, Apple has been able to consistently increase its profits every year in the past decade through a number of innovative and highly desirable products (e. g. Mac, iphone, ipod, ipad, itunes). Due to the increase in Apple s profits, the value of the company as well as its stock price have also increased. So as to be able to follow this development more easily, share price behavior is presented on a graph. In technical language, these graphs are called charts. Figure 5: Price trend Apple Inc. 350 300 250 Price in USD 200 150 100 50 0 Jan 1991 Jan 1992 Jan 1993 Jan 1994 Jan 1995 Jan 1996 Jan 1997 Jan 1998 Jan 1999 Jan 2000 Jan 2001 Jan 2002 Jan 2003 Jan 2004 Jan 2005 Jan 2006 Jan 2007 Jan 2008 Jan 2009 Jan 2010 Jan 2011 Source: Bloomberg 9
Shares in the cell phone pioneer Nokia rose constantly throughout the 1990s. At the peak of the global internet hype in early 2000, Nokia shares were trading at more than 60 Euros. In the last decade, Nokia retained its position as the world s largest cell phone producer. In contrast to its competitors (Apple, HTC, etc.), however, Nokia was unable to establish itself in more profitable market segments such as cell phones with internet access (smart phones). Shareholders responded to this development by selling their shares (Status: January 2011). Figure 6: Price trend Nokia 70 60 50 Price in EUR 40 30 20 10 0 Jan 1991 Jan 1992 Jan 1993 Jan 1994 Jan 1995 Jan 1996 Jan 1997 Jan 1998 Jan 1999 Jan 2000 Jan 2001 Jan 2002 Jan 2003 Jan 2004 Jan 2005 Jan 2006 Jan 2007 Jan 2008 Jan 2009 Jan 2010 Jan 2011 Source: Bloomberg 10
Mutual Funds If Christian were to buy stock in just one company, he would, on the one hand, have a chance of making a handsome profit; on the other hand, he also runs the risk of suffering a severe loss, as one can see from the difference in share price performance of Nokia shares as compared to Apple shares from 2001 to early 2011. Consequently, buying shares in a single corporation entails a significant risk. If, however, Christian were to invest in a variety of different stocks, he would be able to balance out the negative price development of a specific stock. Mutual funds offer a simple solution for private investors. Mutual funds raise money from many individual investors. The fund manager determines what shares the fund should buy with the money raised. The mutual fund is required to invest its funds in a number of different corporations, so that the negative price development of individual shares can be balanced out by the positive price development of other shares in the fund. An example of a successful mutual fund LBBW Aktien Deutschland investment fund often invests its shareholders money in some of the largest German corporations. Since its launch on 06/10/1992, the investment fund has gained 301.58 % (as of 01/31/2011). During this timespan, the investment fund experienced extreme price fluctuations, ranging from 60 to 160 Euros. From 2005 until the middle of 2007, the fund experienced strong earnings growth due to strong global growth in the background (booming world economy). In 2008, the fund suffered heavy losses with the outbreak of the international financial crisis (triggered by the collapse of the U.S. real estate market due to careless lending by banks to low-income segments). Since German companies are dependent on foreign markets for a major portion of their turnover (e. g. the automotive sector s biggest market by sales is the USA), they suffered significantly from the crisis. However, with the recovery of the global economy in 2009, LBBW Aktien Deutschland investment fund was able to recoup a significant portion of the losses it had suffered. 11
Figure 7: Price trend LBBW Aktien Deutschland investment fund 180 160 140 120 Price in EUR 100 80 60 40 20 0 Okt 1992 Okt 1993 Okt 1994 Okt 1995 Okt 1996 Okt 1997 Okt 1998 Okt 1999 Okt 2000 Okt 2001 Okt 2002 Okt 2003 Okt 2004 Okt 2005 Okt 2006 Okt 2007 Okt 2008 Okt 2009 Okt 2010 Source: LBBW Asset Management Investmentgesellschaft mbh (www.lbbw-am.de) Fund Performance 1 year (01/31/2010-01/31/2011): 26.37 % 3 years (01/31/2008-01/31/2011): 07.66 % 5 years (01/31/2006-01/31/2011): 20.33 % 10 years (01/31/2001-01/31/2011): 06.53 % Since its launch (10/06/1992-01/31/2011):0301.58 % 12
Evaluation Criteria for Investments If you want to invest money, ask yourself the following questions: 1. How high are the returns on this investment? 2. Is the money invested safely or are you at risk of losing it? 3. Can you access your money at any time or are you subject to restrictions? These three questions can be grouped according to the following criteria: Profitability (return) Safety (investment risk) Liquidity (availability) Profitability Profitability is the increase in value of an investment after deducting all fees incurred. If an investment leads to financial gain, the investment is profitable. If a loss results, the profitability of an investment is negative. The term return is used to express the profitability of an investment. If an investment of 100 Euros, for example, results in a profit of 2 Euros in a year, the return rate is said to be 2 %. If the profit on an investment of 500 Euros is 10 Euros in a year, the return rate is also 2 %. Calculation of the return for one year: Return = 100 % Investment * Profit Safety Risks of Investment In general, the higher the chances of a return on an investment are, the greater the risk. Based on past data, the chances of a return over the long term are much higher for shares and mutual funds than for the other forms of investment described above (savings books, checking accounts, fixed deposits). Investment risk can range from losing a portion of the money invested to a total loss. Shares and mutual funds are exposed to the risk of falling share prices. In contrast, savings books, checking accounts and fixed deposits do not entail any price risk and are also insured to a certain extent against default by the government and through the banks own safety measures. Nonetheless, it is still advisable for investors to check with their local bank to what extent an investment is protected against default. 13
Liquidity (Availability) The easier an investor can access his money, the easier he can react to unexpected situations. The attractiveness of the investment increases with its liquidity. Shares and mutual funds can be sold at any time on the stock markets. One can also withdraw money from a savings book or a money market account at any time. However, in the case of savings books, one can only withdraw a specific maximum each month, otherwise the bank deducts a portion of the interest credited on the amount. One cannot access fixed deposits before they mature; or, at most, in exceptional cases at the cost of losing a significant portion of the interest. The tension between risk, return and availability (liquidity) is referred to as the magic triangle of investment: Profitability (Return) Security Liquidity (Risk) (Availability) 14
Exercise 2 The different forms of investment can be distinguished by using the criteria of profitability, liquidity and safety. Rate the investment in the subsequent worksheet. Hint: Use the words high, medium and low. Shares Equity funds Fixed deposit Savings book Money market account Return Safety Liquidity Exercise 3 Evaluate the correctness of the following statements and justify your response. Equity investment funds are riskier than single shares. Savings books, money market accounts and fixed deposits are not subject to price risk. Savings books, money market accounts and fixed deposits are protected through various security measures by the banks. 15
Optional educational game: DAX 30 Game The aim of the DAX 30 Game is to give students a feel for investments in corporations. The students thereby learn important terminology from the capital market and come to know the factors that influence stock prices. Approach The students should form multiple groups, each of which focuses on at least five corporations included in the DAX 30. One group should focus on automotive and mechanical engineering stocks, another on banking and insurance stocks, another on consumer and energy stocks, another on pharmaceutical and chemical stocks and another on technology and other stocks. This breakup leads to a desirable diversification of areas. The students should study the business area and future plans of their companies, and create a short corporate profile for each company. The most reliable information is to be found on the company website under investor relations. After each group has studied its own corporation, the group should decide which corporation is most suitable for an investment. The students should thereby recognise that every corporation entails different risks and opportunities. For example, a energy supplier can be considered low-risk, as energy is always needed. In contrast, the danger that a company is not aware of a technological development or backs the wrong technology is significantly higher in the technology sector. After every group has chosen a stock investment, the group should present its decision to the entire class. Thereafter, the class should discuss the latest news on the company and how stock markets reacted to this news (with positive, rising stock prices or with negative, falling stock prices) turn-by-turn. The group s decision should thus be critically examined in this way, and, under circumstances, dealt with appropriately. One can also replicate the class s portfolio with its individual corporations on the website of the Stuttgart Stock Exchange. Using the portfolio function, students can look up the share price development and news on or from a company. In order to do this, the class must first register as a new user on the Stuttgart Stock Exchange s website by clicking on New Registration. Once the class is registered, it can virtually follow the price movements of individual shares and of their portfolio as a whole. However, it cannot buy or sell actual shares. Stuttgart Stock Exchange on the internet: www.boerse-stuttgart.de DAX 30 is a registered trademark of Deutsche Börse AG. 16