Saving and Investing are Risky Business

LESSON DESCRIPTION AND BACKGROUND
In this lesson, the students learn that savings and investment instruments carry various types of risk. Students learn about the risks of inflation, interest rate fluctuation, and financial loss. With any type of investment, there is at least one kind of risk. They also learn that risk must be measured against reward. This lesson is correlated with national standards for mathematics and economics as well as the national guidelines for personal financial management.

ECONOMIC AND PERSONAL FINANCE CONCEPTS:
Opportunity cost, inflation risk, interest rate risk, risk of financial loss, savings account, certificate of deposit, money market deposit account, U.S. savings bond

Fitness Focus
Student Objectives:
At the end of this lesson, the student will be able to:

1. Introduce the lesson by noting that one reason people use savings accounts is that they believe that savings accounts are riskfree. Explain that most banks and savings and loan associations carry insurance on their savings accounts through the Federal
Deposit Insurance Corporation (FDIC). The FDIC insures an individual’s accounts in one institution up to $100,000. In other words, if
the bank or savings and loan closes and it is insured (most are), the depositors will get all their money back from the FDIC if
they have $100,000 or less deposited in that bank. The same type of insurance is available from the National Credit Union Association (NCUA) for credit unions. The federal government guarantees the repayment of savings bonds, which provides about as much security as one can have in a savings plan.

2. Explain that the amount of the principal is secure with these plans. There is little risk of losing one’s investment or principal. Principal is the amount of money placed in the account by the saver. Savers do not risk losing their savings; however, they do face other risks that are important to understand.
3. Have the students read the Warm-Up, Fitness Vocabulary, Muscle Developers, and Showing Your Strength for Lesson 11 in Student Workouts. Discuss the concepts that are difficult for the students.

EXERCISE
1. Inflation Risk
a. Invite a volunteer to the front of the class. Give the volunteer 100 pennies and explain that each penny represents $10. Ask the class how much money the volunteer has? ($1,000) Explain to the volunteer that she or he could purchase a top-of-the-line stereo system for $1,000 but has decided to wait until next year to purchase the stereo system. He or she places the money in a regular s savings account. Even though the interest rate on a regular savings account can fluctuate over time, explain that the interest rate did not change throughout the year and the volunteer received three percent interest on his or her $l,000. Ask how much the volunteer has after one year in his/her account? ($l,030) You may have to review how interest is figured.

b. Display Visual 11.1, Nothing is Risk-Free and discuss inflation risk. This is the risk that the value of investments will not increase at least as rapidly as the rate of inflation. Inflation is a general rise in prices. When prices increase, your money is worth less and you lose buying power.

c. Explain to the class that the rate of inflation for the year was four percent. If the price of the stereo increased at the rate of inflation, the price of the stereo will now be priced at $1,040 (1.04 x $l000). Ask the class if the volunteer has enough money to buy the stereo now. (No, the saver is worse off now because he or she has lost purchasing power over the year.) The student was guaranteed that she/he would not lose any of the money placed in the account and that interest would be gained, but inflation risk shows that the earned interest was not sufficient to maintain the purchasing power of the money. Have the student return to his/her seat.

d. Repeat that inflation is a general rise in the price level. This means that not all items increase in price, but on average prices have increased. Some items may not increase at the rate of inflation, while others will exceed this rate.

e. Refer the students to Exercise 11.1, Now or Later? in Student Workouts and, if possible, display pictures of the five items cut from store ads or magazines. The students will calculate the percentage change in the price of each item.

Discuss the questions on Exercise 11.1. The percentage change answers are listed in the table below. The amount in the account at
the end of the year is $1,004.25.

1. The computer and the camcorder.
2. None.
3. One year’s wardrobe.
4. Computer.
5. The television, the car stereo system, and one year’s wardrobe.

Item	Last year’s price	This year’s price	% change
computer	$ 997.00	$ 897.30	-10
digital camcorder	$1,005.00	$ 954.75	-5
digital television	$1,000.00	$1,070.00	+7
car stereo system	$ 995.00	$1,074.60	+8
one year’s wardrobe	$ 995.00	$1,094.50	+10

f. Direct the students back to the description of certificates of deposits in Reading 7.1 (from Lesson 7 in Student Workouts).
Explain that certificates of deposit (CDs) offer a higher interest rate than a statement savings account and a guarantee that the interest rate will stay the same throughout the period that the saver owns the CD. Suppose someone purchases a CD for for $1,000 that pays six percent interest annually but must be held by the saver for two years. Ask the class to calculate the amount of interest the saver will get over two years. Explain that in this case, the bank will compound the interest annually, meaning it will award interest at the end of year one and then again at the end of year two.

($1,000 x .06 x 1 = $1,060 after year one. $1,060 x .06 x 1 x $1,123.60 after two years).

g. Instruct the class to calculate how much the digital television, the price of which is $1,000 this year, would cost after two years at an annual inflation rate of four percent the first year and seven percent the second year. We are assuming that the television increases in price at the same rate as inflation.

($1,000 x .04 = $1,040 after year one. $1,040 x .07 = $1,112.80 after year two).

Ask if the saver would have enough money to buy the television if the money were kept in a CD. (Yes.) Explain that the saver retained more purchasing power because he or she gained over the inflation rate the first year. In this case, the purchasing power was maintained but the savings gained very little new purchasing power.

a. Point out a second type of risk, referring back to Visual 11.1. Interest rate risk is the risk that interest rates may change while the saver is “locked in” to a time deposit. This can be good for the saver if interest rates go down. If interest rates go up, the saver will “lose” the additional interest possible if the rate were not fixed.

b. Indicate that generally as inflation increases, interest rates increase. Notice in the last example that there was a four percent inflation rate one year and a seven percent inflation rate over the next year. During the first year, the CD paid over the inflation rate; in fact, it paid six percent. But during the last year, it did not keep up with inflation because it was locked in at a lower rate. Probably
the new CDs during that second year were yielding more than seven percent. So, during the last year, the money was not earning as much as it could because it was tied up in a savings plan where it could not be removed without penalty.

c. Use Exercise 7.1 to review the nature of the statement savings account, money market deposit account, and U. S. Savings Bond. Point out that the interest rate for the money market deposit account is flexible, as are the interest rates for U.S. Savings Bonds and for statement savings accounts. This is particularly advantageous in an inflationary time. As interest rates spiral upward in the market, these savings instruments also pay a higher rate.

3. Summary Exercise—Refer students to Exercise 11.2, Decisions, Decisions, in Student Workouts, and ask the students
what they would do in the stated situations.

The answers are:
a. Statement savings account would be the best choice; the fact that interest rates may be decreasing is immaterial in this situation
since you want the money readily available, and there is not enough savings for a CD or a money market deposit account.
b. Money market deposit account or statement savings account are the best choices. You have enough savings to secure a
money market deposit account. You want to take advantage of the increasing rates.

c. Certificate of deposit of less than three years would be the best choice because you want to lock in the higher rate. You have enough savings to buy a CD.
d. U.S. Savings Bond would be the best choice; you have a small amount, so CDs and the money market are not available to you; savings bonds generally pay a better rate than statement savings accounts.They can also have a tax advantage, especially if used for education.

e. Money market deposit account or a statement savings account would be the best choice if the periodic withdrawals are unpredictable.

a. Ask if anyone has heard of the “Great Depression”? What happened during that time? Indicate that during that time many people went bankrupt because of their losses on the stock market. This points out a third type of risk, which is the financial risk, or risk of losing principal (the amount invested or saved) or the return on the principal.

b. Show Visual 11.1, which defines the risk of loss as the possibility of losing the amount invested, or the principal.

c. Have the students look at Exercise 7.l again and decide what the financial risk is for these savings plans. (Students should indicate that there is very little risk of loss of principal if a savings bank fails because FDIC insurance protects against loss for savings accounts, certificates of deposits, and money market deposit funds. The United States Government stands behind the repayment of U.S. Savings Bonds. There is a risk of some financial loss for CDs and U.S. Savings Bonds if they are cashed prior to the maturity date.)

d. Ask students why stocks carry substantially more risk of principal loss than the savings plans? (Stocks show ownership in a corporation; there is no insurance or guarantee from the government that the firm will make a profit or be successful.)

a. Indicate that in a market economy, there is a general principle that investments with greater risk have the possibility of a greater return. In order to compare the returns from different saving or investment choices, one must know how to figure the rate of return. The rate of return is based on the percentage return an investment has made during the year.

Suppose that Sue received $50 on her savings account. The amount that she had in her savings account at the beginning of the year was $l,000. She did not put any additional deposits into the account.

d. Indicate that the return for stock is based on two figures—dividends and capital gains or losses. The capital gains or losses are the difference between the purchase price and the market price at the end of the year. Technically, capital gains or losses are figured only when a stock has been sold. For purposes of figuring the rate of return for the year, one must use the end of the year figure. For example, if someone pays $40 for a stock and at the end of the year the stock is selling at $50 the capital gain (if sold) would be $10. If the stock were selling at $30, the capital loss would be $10 per share.

The formula for figuring the rate of return on an investment for a stock is as follows:

Suppose that Justin bought l00 shares of stock at $30 per share at the beginning of the year. The stock paid $2 in dividends per share during the year, and is selling at $31/share at the end of the year. What is the estimated rate of return if one sold the stock at the end of the year?

Distribute Exercise 11.3, Yield to the Investor, that asks students to determine the rate of return on various types of
investments and savings plans.

The answers are as follows:
l. 3%
2. 10%
3. 12%
4. 2%
5. Number three has the best return. Stockholders are entitled to a better return than what is gained from a savings account because they assume more risk in owning stocks.

COOL DOWN
Remind the students that each type of savings or investment instrument carries risk. Review these types of risk by asking the following questions:
Describe inflation risk. (This is the risk that the value of investments will not increase at least as rapidly as the rate of inflation.)
What types of savings instruments that we have studied would carry inflation risk? (All savings instruments carry inflation risk.)
Describe interest rate risk. (This is the risk that interest rates may change while the saver is “locked in” to a deposit for a period of time.)
What types of savings instruments that we have studied would carry higher interest rate risk? (Certificates of deposit.)
Describe risk of financial loss. (This is the risk of losing principal, the amount of money invested.)
Do stocks or bonds generally carry a greater risk of financial loss? (Stocks.)

ASSESSMENT
Have student complete Assessment 11.1, Weighing All the Risks, in Student Workouts.

The answers are:
1. Savings accounts carry an inflation rate risk. Even though the rate increases with the general increase in interest rate, the low rate on these accounts may not keep up with inflation.
2. Primary risks for a certificate of deposit (CD) are interest rate risk and inflation risk. These may be a problem if inflation and interest rates increase during the time of the CD purchasing power decreases. On the other hand, a CD can be beneficial if inflation and interest rates decline during the time interval because the rate is locked in.
3. Primary risk is inflation risk, since the interest rate offered for savings bonds may not be much higher than the inflation rate. There is a financial risk (losing interest earned) if you cash it in early.
4. Risk of financial loss is the major risk of stock investments.

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Reprinted with permission from: Financial Fitness for Life: Shaping Up Your Financial Future Teacher Guide ©National Council on Economic Education