Introduction
Investment is a business process that allows people to create wealth using their money. Investors usually make their investment decisions based on the data derived from the prevailing economies and stock markets. Since there are many ways of making investments, investors make decisions that optimize returns on their investments. Investors can invest in the stock markets, bonds, and savings to earn interest rates. In this case, an investor wants to invest $100,000 either in the common stock or in the bank as savings to earn 5% interest per annual. The investor still has 25 years to attain his retirement age and the total of his living expenses is greater than his income. The liquidity worth of the investor is $1,000,000 in which $400,000 (40%) invested in S&P 500, $400,000 (40%) invested in bond, and $200,000 (20%) invested in bank as savings to earn an interest of 5% annually. Therefore, the essay tries to figure out if removing $100,000 from the savings and investing in the common stock will increase the returns on his investments.
Analysis the Investments
The problem of the investor is that the total living expenses are greater than the income, and thus, he wants to increase returns on his current investments and offset the expenses. To solve the problem, the investor should either retain $100,000 in his savings or remove $100,000 and invest in the common stock market for five years.
Financial analysis of the investment provides the basis for the decision on whether to invest in the savings or the common stock market. From the calculations, it is evident that an investment of $100,000 in the common stock gives more returns than the investment of the same amount in the savings. Hence, based on the calculations, the recommendation is that the investor should invest $100,000 in the common stock market to gain an extra $33,423.
The historical information that supports the investment decision is the average annual return rate for the common stock market from 1928 to 2015. Although the common stock market is volatile and dynamic, the average annual return rate since its commencement has been approximately 10%. The average annual return doubles the interest rate of savings, which means that the investor would double his earnings by investing in the common stock market. Moreover, historical information indicates that the annual return rate of the common stock market reached 28% in 1999, which means that the average annual return rate used will still increase. In the last three years, the annual return rate of the common stock market has been 12%, 15%, and 17% for 2015, 2014, and 2013 respectively. Such historical information supports the investment of $100,000 in the common stock market.
Projections of the annual return rate reveal an increasing trend from the current 12% to more than 20% in the next five years owing to the economic growth and stable global markets. Additionally, if the annual return rate stabilizes in the range of 15-20%, it will give triple returns on the investment of the common stock when compared to the returns on savings. The major economies of the world, which are the United States, European countries, Japan, China, and the United Arab Emirates, have promising futures as they exhibit positive economic growth. Consequently, the growth of these economies will have a positive impact on the annual return rate of the common stock market.
The choice of the common stock market in the investment decision has considerable risk due to the unstable global economies. The intermittent global economic crises have a considerable impact on the return rate of the common stock market. For instance, the global economic crisis of 2008 reduced the annual return rate to -2.19% and made investors incur huge losses on their investments. As the annual return rate is highly variable ranging from 28% in 1999 to -2% in 2008, the analysis has accounted for the risk by taking an average annual return rate of 10% and considering the absence of impending global economic crises.
The industry information that aided in the decision-making is the state of the stock markets and the global economy. After overcoming the global economic crisis of 2008, the common stock market has stabilized and is growing positively. The average annual return rate of the last three years is about 15%, which is significantly higher than the annual return rate of decades that is 10%. Therefore, the average annual return rate of 10% provides for the risk as it considers the volatile stock market and the occurrence of global economic crises within the period of five years. The state of the major global economies is promising as they all exhibit an upward trend in growth. Hence, the promising global growth of economies rules out the risk of a negative return rate in the common stock market. However, the choice of investment relies on the assumptions that the annual return rate will be 10% or higher, the world economies will grow, and the global economic crises will not occur.
Exhibit
Analysis of the Options
Investing $100,000 in savings
Calculation of the Savings
From the case study, the investor has $200,000 as savings, which earn the interest of 5% annually. Therefore, investing this money for 5 years to earn a compound interest of 5% will give the following returns.
Formula
A = P(1+r)n
Where A is the amount, P is the principal, r is the interest rate, and n is the number of years.
In this case,
P = $200,000, r = 0.05, and n = 5
Therefore, A = $200,000 (1 + 0.05)5
A = $200,000(1.05)5
A = $255,256
After five years, the investor will earn $55,256 when he invests $200,000 in a bank that earns 5% interest annually.
Calculation of the Common Stock
From the case study, the investor has $400,000 in the common stock market.
As the S&P returns are highly variable, the average annual return rate for the last 50 years is 10%. In this case, the analysis will use the annualized return rate of 10% in calculating the returns on S&P investment.
With the formula A = P(1+r)n
In this case,
P = $400,000, r = 0.1, and n = 5
Therefore, A = $400,000 (1 +0.1)5
A = $400,000(1.1)5
A = $644,204
The calculation indicates that after five years, the investor will earn $244,204 from the investment of $400,000 in the common stock market that gives an annualized return rate of 10%.
Hence, by choosing to retain his investments as $200,000 in savings that earn 5% per annum and $400,000 in the common stock market that earns annualized return rate of 10%, the investor will earn $299,460 (55,256 + 244,204).
Investing $100,000 in the Common Stock Market
Investing $100,000 in the common market means that the savings will have $100,000 and the common stock market will have $500,000.
Calculation of the Savings
Using the formula, A = P(1+r)n
In this case,
P = $100,000, r = 0.05, and n = 5
Therefore, A = $100,000 (1 + 0.05)5
A = $100,000(1.05)5
A = $127,628
Thus, after five years, the investor will earn $27,628 from the savings of $100,000 at an interest rate of 5% annually.
Calculation of the Common Stock
Removing $100,000 from the savings and investing in the common stock increases the investment to $500,000. To obtain the approximate earnings, the calculation will use an annualized return rate of 10%.
Using the formula A = P(1+r)n
Where P = $500,000, r = 0.1, and n = 5
Therefore, A = $500,000 (1 +0.1)5
A = $500,000(1.1)5
A = $805,255
Therefore, after five years, the investor will earn $305,255 from the investment of $500,000 in the common stock market at an annualized return rate of 10%.
Thus, by choosing to remove $100,000 from the savings and investing in the common stock market, the investor will earn $27,628 from $100,000 savings and $305,255 from $500,000 investments in the stock market. Overall, the investor will earn a total of $332,883 from his investments in savings and the common stock market.
Comparison of the Two Options
The calculations indicate that the two options of investments show that they give different earnings after five years. Retention of $100,000 in the savings to earn an interest rate of 5% annually gives lower earnings than the removal of $100,000 and investing in the common stock market. Specifically, investing in the common stock market earns extra $33,423 ($332,883-$299,460).
Conclusion
The decision to choose the common stock market in the investment of $100,000 for the next five years relies on several critical factors. The first critical factor is the annual return rate which is greater than the interest rate of the savings. The second critical factor is the current state and stability of the stock market. The third critical factor is the robust projection of the annual return of the common stock market and global economic growth.