Organizing Financial Assets
The emphasis in this chapter (and in the text in general) is on financial assets, which, as explained in Chapter 1, arefinancial claims on the issuers of the securities. These claims are marketable securities that are saleable in the various marketplaces discussed in Chapter 4.
Basically, households have three choices with regard to savings options:
1.Hold the liabilities of traditional intermediaries, such as banks, thrifts, and insurance companies. This means holding savings accounts and otherfinancial assets well known to many individual investors.
2.Hold securities directly, such as stocks and bonds, purchased directly through brokers and other intermediaries. This option can also include self-directed retirement plans involving IRAs, 401(k)s, Keoghs, and so forth.
3.Hold securities indirectly, through mutual funds and pension funds. In this case, households leave the investing decisions to others by investing indirectly rather than directly.
A pronounced shift has occurred in these alternatives over time. Households have decreased the percentage of direct holdings of securities and the liabilities of traditional intermediaries and increased their indirect holdings of assets through mutual funds and pension funds.Indirect investing, discussed in Chapter 3, refers to investors owning secu- rities indirectly through investment companies such as mutual funds and exchange traded funds. This method of investing has become tremendously popular in the last few years with individual investors. For example, the assets of mutual funds, the most popular type of investment company, now total approximately $12 trillion.
Households also own a large, and growing, amount of pension fund reserves. Most of this amount is being invested by pension funds, on behalf of households, in equity andfixed- income securities, the primary securities of interest to most individual investors. Pension funds (both public and private) are the largest single institutional owner of common stocks. Investors have $3 trillion1in 401(k) plans.
investors can do both, and often do, investing directly through the use of a brokerage account and investing indirectly in one or more types of investment company. Furthermore, brokerage accounts can accommodate the ownership of investment company shares, thereby combining direct and indirect investing into one account.
3 Today’s investors often engage in both direct and indirect investing in their portfolios.
Brokerage accounts can accommodate both.
A GLOBAL PERSPECTIVE
As noted in Chapter 1, investors should adopt a global perspective in making their investment decisions. The investment alternatives analyzed in this chapter, in particular some money market assets, bonds, and stocks, are available from many foreign markets to U.S. investors.
Thus, the characteristics of these basic securities are relevant whether investors own domestic or foreign stocks, or both. Furthermore, investors must recognize that securities traditionally
E X H I B I T 2 - 1
Major types offinancial assets DIRECT INVESTING
Nonmarketable Savings deposits
Certificates of deposit
Money market deposit accounts U.S. savings bonds
Money market Treasury bills
Negotiable certificates of deposit Commercial paper
Eurodollars
Repurchase agreements Banker’s acceptances
Capital market Fixed income
Treasuries Agencies Municipals Corporates Equities
Preferred stock Common stock
Derivatives market Options
Future contracts INDIRECT INVESTING Investment companies Unit investment trust
Open end
Money market mutual fund Stock, bond, and income funds Closed end
Exchange-traded funds
thought of as U.S. securities are, in reality, heavily influenced by global events. To illustrate, in 2010, GE had profits of $14 billion, only $5 billion of which came from U.S. operations.
Clearly, GE is heavily influenced by global events.
U.S. investors can choose to purchase foreign stocks directly. Alternatively, many U.S.
investors invest internationally by turning funds over to a professional investment organiza- tion, the investment company, which makes all decisions on behalf of investors who own shares of the company.1 Regardless, investors today must understand we live in a global environment that will profoundly change the way we live and invest. The simple fact is that while the United States is and will continue to be a major player in thefinancial markets, it no longer dominates as it once did.
Nonmarketable Financial Assets
We begin our discussion of investment alternatives with those that are nonmarketable simply because most individuals will own one or more of these assets regardless of what else they do in the investing arena. For example, approximately 15 percent of totalfinancial assets of U.S.
households are in the form of deposits, including checkable deposits and currency, and time and savings deposits. Furthermore, these assets serve as a good contrast to the marketable securities we will concentrate on throughout the text.
A distinguishing characteristic of these assets is that they represent personal transactions between the owner and the issuer. That is, you as the owner of a savings account at a credit union must open the account personally, and you must deal with the credit union in main- taining the account or in closing it. In contrast, marketable securities trade in impersonal markets—the buyer (seller) does not know who the seller (buyer) is, and does not care.
These are “safe” investments, occurring at (typically) insured financial institutions or issued by the U.S. government. At least some of these assets offer the ultimate inliquidity, which can be defined as the ease with which an asset can be converted to cash. Thus, we know we can get all of our money back from a savings account, or a money market deposit account, very quickly.
Exhibit 2-2 describes the four major nonmarketable assets held by investors. Innovations have occurred in this area. For example, the Treasury now offersI bonds, or inflation-indexed savings bonds. The yield on these bonds is a combination of a fixed rate of return and a semiannual inflation rate.2
Example 2-1
Coca-Cola is justifiably famous for its brand name and its global marketing efforts. Its success, however, is heavily dependent on what happens in the foreign markets it has increasingly penetrated. If foreign economies slow down, Coke’s sales may be hurt. Furthermore, Coke must be able to convert its foreign earnings into dollars at favorable rates and repatriate them.Therefore, investing in Coke involves betting on a variety of foreign events.
1We will discuss thefirst alternative in this chapter and the second in Chapter 3.
2I bondsare purchased at face value. Earnings grow inflation-protected for maturities up to 30 years. Face values range from $50 to $10,000. Federal taxes on earnings are deferred until redemption.
Liquidity The ease with which an asset can be bought or sold quickly with relatively small price changes
Money Market Securities
Money marketsinclude short-term, highly liquid, relatively low-risk debt instruments sold by governments,financial institutions, and corporations to investors with temporary excess funds to invest. This market is dominated by financial institutions, particularly banks, and gov- ernments. The size of the transactions in the money market typically is large ($100,000 or more). The maturities of money market instruments range from one day to one year and are often less than 90 days.
Some of these instruments are negotiable and actively traded, and some are not.
Investors may choose to invest directly in some of these securities, but more often they do so indirectly through money market mutual funds (discussed in Chapter 3), which are invest- ment companies organized to own and manage a portfolio of securities and which in turn are owned by investors. Thus, many individual investors own shares in money market funds that, in turn, own one or more of these money market certificates. Exhibit 2-3 describes the major money market securities of most interest to individual investors.3
E X H I B I T 2 - 2
Important Nonmarketable Financial Assets 1. Savings accounts. Undoubtedly the best-known type of
investment in the United States, savings accounts are held at commercial banks or at“thrift”institutions such as savings and loan associations and credit unions. Savings accounts in insured institutions (and your money should not be in a noninsured institution) offer a high degree of safety on both the principal and the interest earned on that principal. Liquidity is taken for granted and, together with the safety feature, probably accounts substantially for the popularity of savings accounts. Most accounts permit unlimited access to funds although some restrictions can apply. Rates paid on these accounts are stated as an Annual Percentage Yield (APY).
2. Nonnegotiable certificates of deposit. Commercial banks and other institutions offer a variety of savings certificates known as certificates of deposit (CDs). These certificates are avail- able for any amount and for various maturities, with higher rates offered as maturity increases. (Larger deposits may also command higher rates, holding maturity constant.) These CDs are meant to be a buy-and-hold investment. Although some CD issuers have now reduced the stated penalties for early withdrawal, and even waived them, penalties for early withdrawal of funds can be imposed.
3. Money market deposit accounts (MMDAs). Financial institu- tions offer money market deposit accounts (MMDAs) with
no interest rate ceilings. Money market “investment” accounts have a required minimum deposit to open, pay competitive money market rates and are insured up to
$100,000 by the Federal Deposit Insurance Corporation (FDIC), if the bank is insured. Six pre-authorized or auto- matic transfers are allowed each month, up to three of which can be by check. As many withdrawals as desired can be made in person or through automated teller machines (ATMs), and there are no limitations on the number of deposits.
4. U.S. government savings bonds. The nontraded debt of the U.S. government, savings bonds, are nonmarketable, non- transferable, and nonnegotiable, and cannot be used for collateral. They are purchased from the Treasury, most often through banks and savings institutions. Series EE bonds in paper form are sold at 50 percent of face value, with denominations of $50, $75, $100, $200, $500,
$1,000, $5,000, and $10,000. Electronic EE bonds are sold at face value and now earn afixed rate of return.
A second series of savings bonds is theI bond, sold in both electronic and paper form. A comparison of these two savings bonds is available at http://www.savingsbonds.
gov/indiv/research/indepth/ebonds/res_e_bonds_eecompa rison.htm.
3Other money market securities exist, such as federal funds, but most individual investors will never encounter them.
Money Markets The market for short-term, highly liquid, low-risk assets such as Treasury bills and negotiable CDs