Investment Decisions

Chapter 1
The Investment Environment
Copyright 2008 Pearson Addison-Wesley. All rights reserved.
What is an Investment?
Investment: any vehicle into which funds can be placed with the expectation that it will generate positive income and/or that its value will be preserved or increased Return: the reward for owning an investment
Current income Increase in value
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Types of Investments
Securities or Property
Securities: stocks, bonds, options Real Property: land, buildings Tangible Personal Property: gold, artwork, antiques
Direct or Indirect
Direct: investor directly acquires a claim Indirect: investor owns an interest in a professionally managed collection of securities or properties
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Types of Investments (cont'd)

Debt, Equity or Derivative Securities
Debt: investor lends funds in exchange for interest income and repayment of loan in future (bonds) Equity: represents ongoing ownership in a business or property (common stocks) Derivative Securities: neither debt nor equity; derive value from an underlying asset (options)
Low Risk or High Risk

Risk: chance that actual investment returns will differ from those expected
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Types of Investments (cont'd)

Short-Term or Long-Term
Short-Term: mature within one year Long-Term: maturities of longer than a year
Domestic or Foreign
Domestic: U.S.-based companies Foreign: foreign-based companies
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Suppliers and Demanders of Funds

Government
Federal, state and local projects & operations Typically net demanders of funds
Business
Investments in production of goods and services Typically net demanders of funds
Individuals
Some need for loans (house, auto) Typically net suppliers of funds
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Figure 1.1 The Investment Process
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Types of Investors
Individual Investors
Invest for personal financial goals (retirement, house)
Institutional Investors
Paid to manage other peoples money Trade large volumes of securities Include: banks, life insurance companies, mutual funds and pension funds
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Table 1.1 Overview of Investment Vehicles
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Steps in Investing
Step 1: Meeting Investment Prerequisites
a. Adequately provide for necessities of life, including funds for meeting emergency cash needs b. Adequate protection against losses from death, illness and disability
Step 2: Establishing Investment Goals

Examples include: a. Accumulating retirement funds b. Enhancing current income c. Saving for major expenditures d. Sheltering income from taxes
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Steps in Investing (cont'd)

Step 3: Adopting an Investment Plan
a. Develop a written investment plan b. Specify target date and risk tolerance for each goal
Step 4: Evaluating Investment Vehicles

a. Assess potential return and risk b. Chapter 4 will cover risk in detail
Step 5: Selecting Suitable Investments

a. Research and gather information on specific investments b. Make investment selections
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Steps in Investing (cont'd)

Step 6: Constructing a Diversified Portfolio
a. Use portfolio comprised of different investments b. Diversification can increase returns or decrease risks (Chapter 5 will cover diversification in detail)
Step 7: Managing the Portfolio

a. Compare actual behavior with expected performance b. Take corrective action when needed
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Taxes in Investing Decisions

Its not what you make, its what you keep that is important. Tax Planning Involves:
The desired return after-taxes Type of income received from investments Timing of profit-taking and loss recognition
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Taxes in Investing Decisions (cont'd)

Basic Sources of Taxes in Investing
Federal: tax rates from 10% to 35% State taxes
Types of Income for Individuals

Active Income: income from working (wages, salaries, pensions) Portfolio Income: income from investments (interest, dividends, capital gains) Passive Income: income from special investments (rents from real estate, royalties, limited partnerships)
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Ordinary Income
Active, portfolio and passive income included Taxed at progressive tax rates (rates go up as income goes up)
Capital Gains and Losses

Capital Asset: property owned and used by taxpayer, including securities and personal residence Capital Gain: amount by which the proceeds from the sale of a capital asset are more than its original purchase price Capital Loss: amount by which the proceeds from the sale of a capital asset are less than its original purchase price
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Table 1.2 Tax Rates and Income Brackets for Individual and Joint Returns (2006)
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Taxation of Capital Gains
Capital assets held less than one year: ordinary income tax rates Capital assets held more than one year: 15% (or 5 %)
Taxation of Capital Losses

Capital losses can be used to offset capital gains Up to $3,000 per year of capital losses can be used to offset ordinary income (such as wages)
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Tax-Advantaged Retirement Vehicles

Allows taxes to be deferred until withdrawn in future Employer-sponsored plans
Profit-sharing plans, thrift and savings plans, and 401(k) plans Keogh plans and SEP-IRAs
Self-employed individual plans

Individual plans
Individual retirement arrangements (IRAs) and Roth IRAs
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Investing Decisions Over Investor Life Cycle

Investors tend to follow different investment philosophies as they move through different stages of the life cycle. Youth Stage
Twenties and thirties Growth-oriented investments Higher potential growth; Higher potential risk Stress capital gains over current income
What are some examples of age-appropriate investments?

Common stocks, options or futures
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Investing Decisions Over Investor Life Cycle (cont'd)

Middle-Aged Consolidation Stage
Ages 45 to 60 Family demands & responsibilities become important (education expenses, retirement savings) Move toward less risky investments to preserve capital Transition to higher-quality securities with lower risk
What are some examples of age-appropriate investments?

Low-risk growth and income stocks, preferred stocks, convertible stocks, high-grade bonds
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Investing Decisions Over Investor Life Cycle (cont'd)

Retirement Stage
Ages 60 and older Preservation of capital becomes primary goal Highly conservative investment portfolio Current income needed to supplement retirement income
What are some examples of ageappropriate investments?

Low-risk income stocks and mutual funds, government bonds, quality corporate bonds, bank certificates of deposit
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Investing in Different Economic Environments

Market Timing: process of identifying the current state of the economy/market and assessing the likelihood of its continuing on its present course Three Conditions of the U.S. Economy
Recovery or expansion
Decline or recession
Corporate profits are up, which helps stock prices Growth-oriented and speculative stocks do well Values and returns on common stocks tend to fall
Change in the general direction of the economys movement

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Figure 1.2 Different Stages of an Economic/Market Cycle
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Investing Decisions and Interest Rates

Interest rates are the single most important variable in determining returns to investors for bonds and fixed-income securities. Interest rates and bond prices move in opposite directions:
When interest rates go up, bond prices go down When interest rates go down, bond prices go up
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The Role of Short-Term Vehicles

Liquidity: the ability of an investment to be converted into cash quickly and with little or no loss in value Primary use is for emergency cash reserve or to save for a specific short-term financial goal
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The Advantages and Disadvantages of Short-Term Vehicles
Advantages
High liquidity Low risks of default
Disadvantages
Low levels of return Loss of potential purchasing power from inflation
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Chapter 1
Additional Chapter Art
Table 1.3 Popular Short-Term Investment Vehicles (Part A)
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Table 1.3 Popular Short-Term Investment Vehicles (Part B)
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Table 1.3 Popular Short-Term Investment Vehicles (Part C)
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Investment Suitability
Short-Term Vehicles are used for:
Savings
Emphasis on safety and security instead of high yield
Investment
Yield is often as important as safety Used as component of diversified portfolio Used as temporary outlet waiting for attractive permanent investments
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Table 1.4 A Scorecard for Short-Term Investment Vehicles
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Chapter 2
Markets and Transactions
Types of Markets
Money Markets: the market where short-term securities are bought and sold Capital Market: the market where long-term securities such as stocks and bonds are bought and sold Primary Market: the market in which new issues of securities are sold to the public Secondary Market: the market in which securities are traded after they have been issued
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Primary Markets
Initial Public Offering (IPO)
First public sale of a companys stock Requires SEC approval
Three Choices to Market Securities in Primary Market

Public offering Rights offering Private Placement
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Going Public: The IPO Process

Underwriting the offering: promoting the stock and facilitating the sale of the companys shares Prospectus: registration statement describing the issue and the issuer Red Herring: preliminary prospectus available during the waiting period Quiet Period: time period after prospectus is filed when company must restrict what is said about the company
Road Show: series of presentations to potential investors
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The Investment Bankers Role

Underwriting the Issue: purchases the security at agreed-on price and bears the risk of reselling it to the public Underwriting Syndicate: group formed by investment banker to share the financial risk of underwriting Selling Group: other brokerage firms that help the underwriting syndicate sell issue to the public Tombstone: public announcement of issue and role of participants in underwriting process Investment Banker Compensation: typically in the form of a discount on the sale price of the securities
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Figure 2.2 The Selling Process for a Large Security Issue
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Secondary Markets
Secondary Market: the market in which securities are traded after they have been issued Role of Secondary Markets
Provides liquidity to security purchasers Provides continuous pricing mechanism
Securities Exchanges: forums where buyers and sellers of securities are brought together to execute trades Nasdaq Market: employs an all-electronic trading platform to execute trades Over-the-counter (OTC) Market: involves trading in smaller, unlisted securities
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Broker Markets and Dealer Markets

Broker Markets: consists of national and regional securities exchanges
60% of the total dollar volume of all shares in U.S. stock market trade here New York Stock Exchange (NYSE) is largest and most well-known Trades are executed when a buyer and a seller are brought together by a broker and the trade takes place directly between the buyer and seller
Dealer Markets: consists of both the Nasdaq market and the OTC market
Trades are executed with a dealer (market maker) in the middle. Sellers sell to a market maker at a stated price. The market maker then offers the securities to a buyer.
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Figure 2.3 Broker and Dealer Markets
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Broker Markets
The New York Stock Exchange (NYSE)
Largest stock exchangeover 2,700 companies Over 350 billion shares of stock traded in 2005 Accounts for 90% of stocks traded on exchanges Specialists make transactions in key stocks Strictest listing policies
The American Exchange (AMEX)
About 700 companies and 4% of stocks traded Major market for Exchange Traded Funds Typically smaller and younger companies who cannot meet stricter listing requirements for NYSE
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Broker Markets (contd)

Regional Stock Exchanges
Typically lists between 100500 companies, usually with local and regional appeal Listing requirements are more lenient than NYSE Often include stocks that are also listed on NYSE or AMEX Best-known: Midwest, Pacific, Philadelphia, Boston, and Cincinnati Allows trading of options Best-known: Chicago Board Options Exchange (CBOE)
Options Exchanges
Futures Exchanges
Allows trading of financial futures Best-known: Chicago Board of Trade (CBT)
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Dealer Markets
No centralized trading floor; comprised of market makers linked by telecommunications network Both IPOs and secondary distributions are sold on OTC
40% of the total dollar volume of all shares in U.S. stock market trade here Both IPOs and secondary distributions are sold on OTC
Bid Price: the highest price offered by market maker to purchase a given security
Ask Price: the lowest price at which a market maker is willing to sell a given security
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Dealer Markets
Nasdaq Largest dealer market Lists large companies (Microsoft, Intel, Dell, eBay) and smaller companies Over-the-counter (OTC) Bulletin Board Lists smaller companies that cannot or dont wish to be listed on Nasdaq Companies are regulated by SEC Over-the-counter (OTC) Pink Sheets Lists smaller companies that are not regulated by SEC Liquidity is minimal or almost non-existent Very risky; many nearly worthless stocks Copyright 2008 Pearson
Addison-Wesley. All rights reserved. 2-45
Alternative Trading Systems

Third Market
Large institutional investors go through market makers that are not members of a securities exchange Institutional investors (mutual funds, life insurance companies, pension funds) receive reduced trading costs due to large size of transactions
Fourth Market
Large institutional investors deal directly with each other to bypass market makers Electronic Communications Networks (ECNs) allow direct trading ECNs most effective for high-volume, actively traded securities
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General Market Conditions

Bull Market

Favorable markets Rising prices Investor/consumer optimism Economic growth and recovery Government stimulus
Unfavorable markets Falling prices Investor/consumer pessimism Economic slowdown Government restraint
Bear Market
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Globalization of Securities Markets

Diversification: the inclusion of a number of different investment vehicles in a portfolio to increase returns or reduce risks Use of International Securities Improves Diversification
More industries and securities available Securities denominated in different currencies Opportunities in rapidly expanding economies
International Investment Performance

Opportunities for high returns Foreign securities markets do not necessarily move with the U.S. securities market Foreign securities markets tend to be more risky than U.S. markets
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Globalization of Securities Markets (contd)

Indirect Ways to Invest in Foreign Securities
Purchase shares of U.S.-based multinational with substantial foreign operations
Direct Ways to Invest in Foreign Securities

Purchase securities on foreign stock exchanges Buy securities of foreign companies that trade on U.S. stock exchanges Buy American Depositary Receipts (ADRs): dollar denominated receipts for stocks of foreign companies held in vaults of banks
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Risks of International Investing

Usual Investment Risks Still Apply Government Policies Risks
Unstable foreign governments Different laws in trade, labor or taxation Different economic and political conditions Less stringent regulation of foreign securities markets
Currency Exchange Rate Risks
Value of foreign currency fluctuates compared to U.S. dollar Value of foreign investments can go up and down with exchange rate fluctuations
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Trading Hours of Securities Markets

Regular Trading Session for U.S. Exchanges and Nasdaq
9:30 A.M. to 4:00 P.M. Eastern time
Extended-Hours Electronic-Trading Sessions

NYSE: 4:15 to 5:00 P.M. Eastern time Nasdaq: 4:00 P.M. to 6:30 P.M. Eastern time Orders only filled if matched with identical opposing orders 24-hour market probably in near future
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Regulation of Securities Markets

Insider Trading
Use of nonpublic information about a company to make profitable securities transactions
Blue Sky Laws

Laws imposed by individual states to regulate sellers of securities Intended to prevent investors from being sold nothing but blue sky
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Securities Act of 1933
Required full disclosure of information by companies
Securities Act of 1934

Established SEC as government regulatory body
Maloney Act of 1938

Allowed self-regulation of securities industry through trade associations such as the National Association of Securities Dealers (NASD)
Investment Company Act of 1940

Created & regulated mutual funds
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Investment Advisors Act of 1940
Required investment advisers to make full disclosure about their backgrounds and their investments, as well as register with the SEC
Securities Acts Amendments of 1975

Abolished fixed-commissions and established an electronic communications network to make stock pricing more competitive
Insider Trading and Fraud Act of 1988

Prohibited insider trading on nonpublic information
Sarbanes-Oxley Act of 2002

Tightened accounting and audit guidelines to reduce corporate fraud
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Basic Types of Securities Transactions

Long Purchase
Investor buys and holds securities
Buy low and sell high Make money when prices go up
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Basic Types of Securities Transactions (contd)

Margin Trading
Uses borrowed funds to purchase securities
Currently owned securities used as collateral for margin loan from broker Margin requirements set by Federal Reserve Board
Determines the minimum amount of equity required On $4,445 purchase with 50% margin requirement, investor puts up $2,222.50 and broker will lend remaining $2,222.50
Can be used for common stocks, preferred stocks, bonds, mutual funds, options, warrants and futures
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Table 2.4 Initial Margin Requirements for Various Types of Securities
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Margin Trading
Advantages
Allows use of financial leverage Magnifies profits
Disadvantages
Magnifies losses Interest expense on margin loan Margin calls
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Margin Formulas
Basic Margin Formula
Value of securities Debit balance Margin Value of securities V D V
Example of Using Margin

V D $6,500 $1,200 Margin 0.815 81.5% V $6,500
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Table 2.3 The Effect of Margin Trading on Security Returns
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Margin Formulas (contd)

Return on Invested Capital
Return on invested capital from a margin transaction Total Total Market Market current interest value of value of income paid on securities securities received margin loan at sale at purchase Amount of equity at purchase
Example of Return on Invested Capital

Return on $100 $125 $7,500 $5,000 $2,475 invested capital 0.99 99% from a margin $2,500 $2,500 transaction
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Basic Types of Securities Transactions

Short Selling
Investor sells securities they dont own
Investor borrows securities from broker Broker lends securities owned by other investors that are held in street name Sell high and buy low Investors make money when stock prices go down
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Short Selling
Advantages
Chance to profit when stock price declines
Disadvantages
Limited return opportunities: stock price cannot go below $0.00 Unlimited risks: stock price can go up an unlimited amount If stock price goes up, short seller still needs to buy shares to pay back the borrowed shares to the broker Short sellers may not earn dividends
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Table 2.5 The Mechanics of a Short Sale
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Chapter 2
Figure 2.1 Cover of a Preliminary Prospectus for a Stock Issue
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Table 2.1 Annual IPO Data, 19962005
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Table 2.2 Important Federal Securities Laws
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Table 2.6 Margin Positions on Short Sales
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Chapter 3
Investment Information and Securities Transactions
Getting Started in Online Investing

Internet is a major force in investing
Makes investing more accessible to more people
Provides access to sophisticated investment tools Convenient, relatively simple, inexpensive and fast
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Online Investment Tools

Investment Education Websites
Offer tutorials, online classes and articles Examples: Investing Online Resource Center, Investor Guide.com, The Motley Fool
Investments Tools Websites

Develop financial plans, set investment goals
Planning Tools Websites

Provides financial calculators Example: Kiplingers Personal Finance
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Figure 3.2 Financial Calculators Concerned with Stocks
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Online Investment Tools

Screening Tools Websites
Sort through databases of stocks, bonds and mutual funds to find those with specific characteristics Examples: Zacks.com and Yahoo!Finance
Charting Tools Websites

Plot performance of stocks over a specified time period Examples: Barchart.com and BigCharts.com
Stock Quotes and Portfolio Tracking Websites

Obtain prices and track stock performance Examples: Yahoo!Finance and MSN Money
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Figure 3.3 Zacks Predefined Screener
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Figure 3.4 Stock Chart for Qualcomm
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Pros and Cons of Using the Internet as an Investment Tool

Exercise same cautions as regular investing Remember: there is no live broker to act as a safety net Be skeptical of free advice online Know what you are buying and from whom Watch out for frequent trading
High transaction costs Higher taxes on short-term gains
Beware of the risks of margin trading

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Types of Investment Information

Descriptive Information factual data on past behavior of economy, market, industry company or given investment vehicle Analytical Information available current data in conjunction with projections and recommendations about potential investments
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Types of Investment Information

Economic and current events
Industry and company information

Information on alternative investment vehicles Price information Information on personal investment strategies
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Sources of Investment Information

Economic and Current Event Information
Finance Journals: Wall Street Journal, Barrons, Investors Business Daily General newspapers: The New York Times Institutional News: Dow Jones, Bloomberg Financial Services, AP, UPI, CNNMoney Business Periodicals: Fortune, Forbes, Business Week, Kiplingers Personal Finance, Money, Smart Money, Worth Government Publications: Economic Report of the President, Federal Reserve Bulletin Special Subscription Services: Kiplinger Washington Letter
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Sources of Investment Information (contd)

Industry and Company Information
General business periodicals: Wall Street Journal, Business Week, Forbes, Fortune Trade publications: periodicals devoted to a specific industry Regulation FD: requires critical company information to be disclosed simultaneously to investment professionals and public Company Web sites Stockholders Reports: report published annually by publicly held corporations Form 10-K: annual statement filed with SEC by all companies with publicly traded stock Freeedgar.com: SEC-maintained website with free access to SEC filings
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Industry and Company Information (contd)
Comparative Data Sources: Dun & Bradstreets Key Business Ratios Subscription Services: Standard & Poors Corporation, Mergent, Value Line Investment Survey Brokerage Reports: research reports available to brokerage firms clients Investment Letters: recommendations of experts in securities investment
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Figure 3.5 A Report Containing Descriptive and Analytical Information
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Price Information
Quotations: use ticker symbols to obtain current price data and statistics on companies
TV sources: Bloomberg TV, CNBC, CNN Headline News
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Other Online Investment Information Sources Financial Portals: supersites on the Web that combine investing features with other personal finance features Bond sites: online resources for bond and interest rate information Mutual fund sites: online resources for mutual fund information International sites: online resources for global investing, from country research to foreign currency exchange Investment discussion forums: websites where investors can exchange opinions on stocks and investing strategies (Examples: Motley Fool, Yahoo! Finance)
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Table 3.3 Symbols for Some Well-Known Companies
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Avoiding Online Scams
Beware of stock manipulators posting false news or overly optimistic opinions Always know your source Beware of pump-and-dumppromoters who hype a stock and sell out on the inflated prices Beware of get-rich-quickpromoters selling worthless investments to nave buyers
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Protect Yourself by Asking Three Key Questions:
Is the investment registered? Is the person licensed and law-abiding? Does the investment sound too good to be true?
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Understanding Market Averages and Indexes

Reasons to use market averages and indexes
Gauge general market conditions Compare your portfolio performance to large, diversified portfolio Study market cycles, trends and behaviors to forecast future market behavior
Stock market averages and indexes measure the general behavior of stock prices over time
Averages reflect the arithmetic average price behavior at a given point in time Indexes measure the current price behavior relative to a base value set at an earlier point in time
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Understanding Market Averages and Indexes (contd)

Dow Jones Industrial Average (DJIA)
Most popular average Comprised of 30 high quality, diversified stocks Tracks overall market activity Stock makeup can change to better reflect the broader stock market
Dow Jones Transportation Average

Comprised of 20 stocks, including railroads, airlines, freight forwarders and mixed transportation companies
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Dow Jones Utilities Average
Comprised of 15 public utility stocks
Standard & Poors 500 Composite Index

Comprised of 500 stocks from major industry sectors More broad-based and representative of overall market than DJIA True index calculated from 19411943 base period closing market values Standard & Poors provide seven other indexes for tracking specific industry sectors
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Figure 3.7 Stock Market Averages and Indexes (July 12, 2006)
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NYSE Composite Index
Includes 2,100 or so stocks listed in NYSE
AMEX Composite Index

Includes all stocks listed on the AMEX
Nasdaq Composite Index

Includes all stocks traded on the Nasdaq stock market Often used to track technology companies behavior due to large technology companies listed with Nasdaq
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Value Line Composite Index
Includes all 1,700 or so stocks tracked by Value Line Uses equal weighting to eliminate the bias of stocks with large total market values
Wilshire 5000 Index Russell 1000 Index Russell 2000 Index
Includes 5,000 stocks traded on the major exchanges

Includes 1,000 largest companies
Includes 2,000 small companies

Tracks stocks trade on foreign exchanges
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Europe/Australia/Far East (EAFE MSCI)

Bond Market Indicators

Bond Yields
Total return on bond purchased at current price and held to maturity Interest +/ changes in bond value Reported as annual rate of return
Dow Jones Corporate Bond Index

Calculated for utility bonds, industrial bonds and a composite bond average
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The Role of Stockbrokers

Stockbrokers
Act as intermediaries between buyers and sellers of securities
Typically paid by commissions
Must be licensed by SEC and securities exchanges where they place orders
Client places order, stockbroker sends order to brokerage firms, who executes order on the exchanges where firm owns seats
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The Role of Stockbrokers (contd)

Brokerage Services
Primary service is to executive clients purchase and sale transactions at the best possible price Clients security certificates often held in street name Street name: stock certificates issued in brokerage firms name, but held in trust for the client who actually owns them Research information is often provided on specific stocks or economic conditions Statements showing detailed account transactions are provided
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Types of Brokerage Firms

Full-Service Broker
Offers broad range of services and products Provides research and investment advice Examples: Merrill Lynch, A.G. Edwards
Premium Discount Broker

Low commissions Limited research or investment advice Examples: Charles Schwab
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Types of Brokerage Firms (contd)

Basic Discount Brokers
Main focus is executing trades electronically online
No research or investment advice Commissions are at deep-discount
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Selecting a Stockbroker
Find someone who understands your investment goals Consider the investing style and goals of your stockbroker Be prepared to pay higher fees for advice and help from fullservice brokers Ask for referrals from friends or business associates
Beware of churning: increasing commissions by causing excessive trading of clients accounts
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Types of Brokerage Accounts

Custodial Account: brokerage account for a minor that requires parent or guardian to handle transactions Cash Account: brokerage account that can only make cash transactions Margin Account: brokerage account in which the brokerage firms extends borrowing privileges Wrap Account: account that shifts investment decisions to a professional money manager and charges a flat annual fee
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Basic Types of Orders

Odd-lot Orders
Orders for less than 100 shares of stock
Round-lot Orders
Orders for a 100-share unit or multiples thereof
Market Orders
Orders to buy or sell stock at best price available when order is placed Fastest way to fill order
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Basic Types of Orders (contd)

Limit Orders
Order to buy at or below a specified price or to sell at or above a specified price If price limits are not met, order is not filled
Fill-or-Kill Orders
Limit orders which is canceled if not filled immediately
Day Orders
Limit orders that expires at end of the day if not filled
Good-til-Canceled (GTC) Orders

Limit orders that remains in effect for six months unless filled, canceled, or renewed
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Basic Types of Orders (contd)

Stop-Loss (Stop) Orders
Typically used to protect investors from stock price declines Suspended order is placed to sell a stock if price reaches or falls below a specified level Orders can be day orders or GTC orders Once activated, becomes a market order Can also use stop orders to buy stocks, such as to limit risk on short sales
Stop-Limit Orders
Orders to sell stock at or better than specified price Prevents sales at undesirable price No sale may occur if prices continues to decline
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Day Trading
Day Trader: an investor who buys and sells stocks quickly throughout the day in hopes of making quick profits
Highly risky, especially if used with margin trading High brokerage commissions due to frequent trading
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Tips for Successful Online Trades

Know how to place and confirm orders Verify stock ticker symbols Use limit orders Check and recheck ordersyou pay for typos Dont get carried away
Follow a strategy Dont churn Avoid or limit margin orders
Open accounts with two brokers Double-check orders for accuracy after completion
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Trading Considerations
Transaction Costs
Fixed commissions used on small trades Negotiated commissions may be used on large trades
Securities Investor Protection Corporation (SIPC)

Protects against broker financial failure Limits up to $500,000 for securities and $100,000 for cash Does not guarantee against churning or bad broker advice
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Trading Considerations (contd)

Mediation
Informal, voluntary dispute resolution process between a customer and a broker Nonbinding if parties cannot agree
Arbitration
Formal dispute resolution process that requires customer and broker to present arguments before a panel Binding arbitration requires customer to accept arbitration panels decisions and give up right to sue broker
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Using an Investment Advisor

Advisors are required to be registered with SEC
No law or regulatory body guarantees competence
Look for advisors with experience Look for advisors with professional designations
Chartered Financial Analyst (CFA) Certified Investment Management Analyst (CIMA) Chartered Investment Counselor (CIC) Certified Financial Planner (CFP) Chartered Financial Consultant (ChFC) Chartered Life Underwriter (CLU) Certified Public Accountant (CPA)
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Paying an Investment Advisor

Typical professional investment advice fees
Small portfolios: annual fees between 2% and 3% of funds under management Large portfolios: annual fees between 0.25% and 0.75% of funds under management
Check the track record and reputation of advisor Expect lots of questions from good advisor to assess your investing expertise
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Investment Clubs
Investments Clubs
A legal partnership formed by investors to pool their knowledge and money
Members make stock recommendations and analyze stock performance Better Investing Community assists in organizing clubs and provides educational tools Better Investing Community has over 200,000 investors in over 16,000 investment clubs
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Chapter 3
Figure 3.1 Investment Resources at the TD Ameritrade Web Site
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Table 3.1 Online Sources for Industry and Company Information
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Figure 3.6 Pages from a Stockholders Report
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Table 3.2 Popular Offerings of the Major Subscription Services
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Table 3.4 Popular Investment Web Sites
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Figure 3.8 The DJIA from January 13, 2006, to July 12, 2006
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Table 3.5 Major Full-Service, Premium Discount, and Basic Discount Brokers
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Chapter 4
Return and Risks
The Concept of Return

Return
The level of profit from an investment, or The reward for investing
Components of Return
Current income: cash or near-cash that is received as a result of owning an investment Capital gains (or losses): the difference between the proceeds from the sale of an investment and its original purchase price
Total Return: the sum of the current income and the capital gain (or loss) earned on an investment over a specified period of time
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Why Return is Important

Allows comparison of actual or expected gains with the levels of gain needed Allows us to keep score on how our investments are doing compared to our expectations Historical Performance
Provides a basis for future expectations Does not guarantee future performance
Expected Return
Return an investor thinks an investment will earn in the future Determines what an investor is willing to pay for an investment or if they are willing to make an investment
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Key Factors in Return

Internal Forces
Type of investment Risks of investment
External Forces
Political environment Business environment Economic environment Inflation Deflation
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Table 4.4 Historical Returns for Popular Security Investments (1926-2005)
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The Time Value of Money and Returns

The sooner you receive a return on a given investment, the better A dollar received today is worth more than a dollar received in the future The sooner your money can begin earning interest, the faster it will grow
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Determining a Satisfactory Investment

Satisfactory Investment: one for which the present value of benefits equals or exceeds the present value of its costs
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Measuring Return
Required Return
The rate of return an investor must earn on an investment to be fully compensated for its risk
Required return Risk-free Risk premium on investment j rate for investment j
Required return Real rate Expected inflation Risk premium on investment j of return premium for investment j
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Measuring Return (contd)

Real Rate of Return
The rate of return that could be earned in a perfect world where all outcomes are known and certainwhere there was no risk Historically, this amount has remained relatively stable at 0.5% to 2%
Expected Inflation Premium

The average rate of inflation expected in the future
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Risk-free Rate
The rate of return that can be earned on a risk-free investment The sum of the real rate of return and the expected inflation premium The most common risk-free investment is considered to be the 3-month U.S. Treasury Bill
Real rate Expected inflation Risk-free rate of return premium
RF r * IP
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Risk Premium
Additional return an investor requires on an investment to compensate for higher risks based upon issue and issuer characteristics Issue characteristics are the type, maturity and features Issuer characteristics are industry and company factors
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Holding Period Return (HPR)

Holding Period: the period of time over which an investor wishes to measure the return on an investment vehicle Realized Return: current return actually received by an investor during the given return period Paper Return: return that has been achieved but not yet realized (no sale has taken place)
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Holding Period Return (HPR)

Holding Period Return
The total return earned from holding an investment for a specified holding period (usually 1 year or less)
Current income Capital gain (or loss) during period during period Beginning investment value
Holding period return
Capital gain (or loss) Ending Beginning during period investment value investment value
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Table 4.6 Key Financial Variables for Four Investment Vehicles
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Using HPR in Investment Decisions

Advantages of Holding Period Return
Easy to calculate Easy to understand Considers current income and growth
Disadvantages of Holding Period Return

Does not consider time value of money Rate may be inaccurate if time period is longer than one year
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Yield: Internal Rate of Return (IRR)

Internal Rate of Return: determines the compound annual rate of return earned on an investment held for longer than one year Yield (IRR) Example: What is the yield (IRR) on an investment costing $1,000 today that you expect will be worth $1,400 at the end of a 5-year holding period?
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Internal Rate of Return (IRR): Using an Excel Spreadsheet
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Using IRR in Investment Decisions (contd)

Advantages of Internal Rate of Return
Uses the time value of money Allows investments of different investment periods to be compared with each other If the yield is equal to or greater than the required return, the investment is acceptable
Disadvantages of Internal Rate of Return

Calculation is complex
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Yield (IRR) for a Stream of Income

Some investments, such as bonds, provide uneven streams of income over the investment period Calculate yield (IRR) by calculating the PV of the different income amounts and adding together
Table 4.7 Yield Calculation for an $1,1,00 Investment
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Internal Rate of Return (IRR): Using an Excel Spreadsheet
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Interest on Interest: The Critical Assumption

Using yield (IRR) to measure return assumes that all income earned over the investment horizon is reinvested at the same rate as the original investment. Reinvestment Rate is the rate of return earned on interest or other income received from an investment over its investment horizon. Fully compounded rate of return is the rate of return that includes interest earned on interest.
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Figure 4.1 Earning Interest on Interest
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Finding Growth Rates

Rate of Growth
The compound annual rate of change in the value of a stream of income
Used to see how quickly a stream of income, such as dividends, is growing
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Finding Growth Rates

Growth Rate Example: Calculate the rate of growth on the dividend stream in Table 4.8.
Table 4.8 Dividends Per Share
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Finding Growth Rates: Using an Excel Spreadsheet
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Sources of Risk
Risk-Return Tradeoff is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa
Risk is the chance that the actual return from an investment may differ from what is expected
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Sources of Risk (contd)

Currency Exchange Risk is the risk caused by the varying exchange rates between the currencies of two countries. (Discussed in Chapter 2) Types of Investments Affected
International stocks or ADRs International bonds
Examples of Currency Exchange Risk

U.S. dollar gets stronger against foreign currency, reducing value of foreign investment Copyright 2008 Pearson

Business Risk is the degree of uncertainty associated with an investments earnings and the investments ability to pay the returns owed to investors. Types of Investments Affected
Common stocks Preferred stocks
Examples of Business Risk

Decline in company profits or market share Bad management decisions
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Financial Risk is the degree of uncertainty of payment resulting from a firms mix of debt and equity; the larger the proportion of debt financing, the greater this risk. Types of Investments Affected
Common stocks Corporate bonds
Examples of Financial Risk
Company cant get additional loans for growth or to fund operations Company defaults on bonds
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Purchasing Power Risk is the chance that changing price levels (inflation or deflation) will adversely affect investment returns. Types of Investments Affected
Bonds (fixed income) Certificates of deposit
Examples of Purchasing Power Risk

Movie that was $8.00 last year is $9.00 this year
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Interest Rate Risk is the chance that changes in interest rates will adversely affect a securitys value. Types of Investments Affected
Bonds (fixed income) Preferred stocks
Examples of Interest Rate Risk
Market values of existing bonds decrease as market interest rates increase Income from an investment is reinvested at a lower interest rate than the original rate
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Liquidity Risk is the risk of not being able to liquidate an investment conveniently and at a reasonable price. Types of Investments Affected
Some small company stocks Real estate
Examples of Liquidity Risk

The price of a house has to be lowered for a quick sale
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Tax Risk is the chance that Congress will make unfavorable changes in tax laws, driving down the after-tax returns and market values of certain investments. Types of Investments Affected
Municipal bonds Real estate
Examples of Tax Risk
Lower tax rates reduce the tax benefit of municipal bond interest Limits on deductions from real estate losses
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Market Risk is the risk of decline in investment returns because of market factors independent of the given investment. Types of Investments Affected
All types of investments
Examples of Market Risk
Stock market decline on bad news Political upheaval Changes in economic conditions
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Event Risk comes from an unexpected event that has a significant and unusually immediate effect on the underlying value of an investment. Types of Investments Affected
All types of investments
Examples of Event Risk

Decrease in value of insurance company stock after a major hurricane Decrease in value of real estate after a major earthquake
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Measures of Risk: Single Asset

Standard deviation is a statistic used to measure the dispersion (variation) of returns around an assets average or expected return Coefficient of variation is a statistic used to measure the relative dispersion of an assets returns; it is useful in comparing the risk of assets with differing average or expected returns
Copyright Higher values for both indicate higher risk 2008 Pearson
Table 4.11 Returns, Standard Deviations, and Coefficients of Variation for Popular Security Investments (19262005)
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Figure 4.2 Risk-Return Tradeoffs for Various Investment Vehicles
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Acceptable Levels of Risk Depend Upon the Individual Investor

Risk-indifferent describes an investor who does not require a change in return as compensation for greater risk Risk-averse describes an investor who requires greater return in exchange for greater risk Risk-seeking describes an investor who will accept a lower return in exchange for greater risk
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Figure 4.3 Risk Preferences
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Steps in the Decision Process: Combining Return and Risk

Estimate the expected return using present value methods and historical/projected return rates
Assess the risk of the investment by looking at historical/projected returns using standard deviation or coefficient of variation of returns
Evaluate the risk-return of each investment alternative to make sure the return is reasonable given the level of risk Select the investment vehicles that offer the highest expected returns associated with the level of risk you are willing to accept
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Investment Decisions

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Investment Decisions

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Chapter 1

The Investment Environment

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Types of Investments (cont'd)

Low Risk or High Risk

Types of Investments (cont'd)

Suppliers and Demanders of Funds

Figure 1.1 The Investment Process

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Table 1.1 Overview of Investment Vehicles

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Step 2: Establishing Investment Goals

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Steps in Investing (cont'd)

Step 4: Evaluating Investment Vehicles

Step 5: Selecting Suitable Investments

Steps in Investing (cont'd)

Step 7: Managing the Portfolio

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Taxes in Investing Decisions

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Taxes in Investing Decisions (cont'd)

Types of Income for Individuals

Taxes in Investing Decisions (cont'd)

Capital Gains and Losses

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Taxes in Investing Decisions (cont'd)

Taxation of Capital Losses

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Tax-Advantaged Retirement Vehicles

Self-employed individual plans

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Investing Decisions Over Investor Life Cycle

What are some examples of age-appropriate investments?

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Investing Decisions Over Investor Life Cycle (cont'd)

What are some examples of age-appropriate investments?

Investing Decisions Over Investor Life Cycle (cont'd)

What are some examples of ageappropriate investments?

Investing in Different Economic Environments

Change in the general direction of the economys movement

Figure 1.2 Different Stages of an Economic/Market Cycle

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Investing Decisions and Interest Rates

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The Role of Short-Term Vehicles

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The Advantages and Disadvantages of Short-Term Vehicles

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Table 1.3 Popular Short-Term Investment Vehicles (Part A)

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Table 1.3 Popular Short-Term Investment Vehicles (Part B)

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Table 1.3 Popular Short-Term Investment Vehicles (Part C)

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Table 1.4 A Scorecard for Short-Term Investment Vehicles

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Three Choices to Market Securities in Primary Market