Using the Correct Domestic Stock Indices,103 Foreign Stock Market Indicators,104 Checking Your Understanding,105 Bond Markets,105. Checking Your Understanding,377 Industry Performance Over Shorter Periods,377 How One Industry Can Have a Big Impact on Investors - The Telecommunications Industry,378.
PART FIVE FIXED-INCOME SECURITIES
Check Your Understanding,381 Qualitative Aspects of Industry Analysis,381 Using Sector/Industry Analysis as an Investor,383. What is Technical Analysis?,424 A Framework for Technical Analysis,426 Check Your Understanding,427 Stock Price and Volume Techniques,427.
ANALYSIS, VALUATION, AND MANAGEMENT 17 Fixed Income Securities Are Available
The importance of sector/industry analysis,375 Why sector/industry analysis is important in the long run,375. Analyzing Return on Assets (ROA),401 Analyzing Return on Equity (ROE),402 The Accounting Determinants of EPS,403.
PART SIX DERIVATIVE SECURITIES
PART SEVEN INVESTMENT MANAGEMENT 21 All Investors Must Consider Portfolio
Investing isan Important
It offers some ideas about what you can reasonably expect to achieve using what you learn, and therefore what you can realistically expect as an investor in today's investing world. Learning how to avoid the many pitfalls that await you as an investor – especially investment scams and fraud – by clearly understanding what you can reasonably expect from investing your money could be the single most important benefit that can be deduced from this text.
SOME DEFINITIONS
Apparently, returns were paid to certain investors from the principal received from other investors. Smart investors quickly learn to say no, thus avoiding many of the pitfalls that await investors every day.
WHY DO WE INVEST?
Funds for investment come from assets already owned, borrowed money and savings or wasted consumption. By forgoing consumption today and investing savings, investors expect to increase their future consumption opportunities by increasing their wealth.
TAKE A PORTFOLIO PERSPECTIVE
Investors also seek to manage their wealth efficiently, to get the most out of it while protecting it from inflation, taxes and other factors.
THE PERSONAL ASPECTS
Build wealth throughout your life In addition to the question of retirement, in the 21st century, studying investments is more important than ever. It's clear that good investment decisions that lead to higher returns can have a huge impact on the wealth you can accumulate.
INVESTMENTS AS A PROFESSION
Individual investor interest in the stock market is best expressed through the power of mutual funds (explained in Chapter 3), a favorite investment vehicle of small investors. It is a professional designation for people in the investment field, not unlike the CPA designation for accountants.
THE BASIS OF INVESTMENT DECISIONS — RETURN AND RISK
When we invest, we may do so based on an expected return, but there is a risk that what we actually end up with when we close the investment - the actual (realized) return - will be different. Risk The possibility that the actual return on an investment will be different from the expected return.
THE GREAT UNKNOWN
Much of the work in this area is in the form of mathematical and statistical models, which have profoundly influenced the study of investment in this country in the last 30 years. Intelligent investors should be aware that the investment decision-making process described above can be long and involved.
A GLOBAL PERSPECTIVE
Moreover, as economies around the world become more integrated, markets become more similar than different.
THE IMPORTANCE OF THE INTERNET
INDIVIDUAL INVESTORS VS. INSTITUTIONAL INVESTORS
Additionally, some opportunities may be more easily exploited by individual investors than by institutional investors. The question of how well individual investors do relative to institutional investors raises the issue of market efficiency, which we examine in Chapter 12.
ETHICS IN INVESTING
Alternatives: InvestmentGeneric
2. Directly hold securities, such as stocks and bonds, purchased directly through brokers and other intermediaries. Households have reduced the proportion of direct holdings of securities and 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 who own securities indirectly through investment companies, such as such as mutual funds and exchange traded funds.
DIRECT INVESTING
Many individual investors thus own shares in money market funds, which in turn own one or more of these money market certificates. 3Other money market securities exist, such as federal funds, but most individual investors will never encounter them.
THE TREASURY BILL
Obviously, the less investors pay for these securities, the higher their return.5,6 Interest rates on T-bills are set at auction each week and therefore reflect current money market conditions. If T-bill rates rise (fall), this generally reflects increased (decreased) demand for funds.
MONEY MARKET RATES
We begin our review of the major types of capital market securities typically held directly by individual investors with fixed income securities. Some of these securities deviate from the traditional form of bonds, but all fixed-income securities have a fixed payment or repayment schedule—they must mature at some future date.
BONDS
16 Contrary to the provision on recall, the sinking fund ensures the orderly retirement of the bond issue during its lifetime. Any part or whole of the bond issue may be withdrawn through the sinking fund until the maturity date.
TYPES OF BONDS
Therefore, with regular inflation, the inflation-adjusted principal increases and the dollar amount of each interest payment increases. Taxes must be paid each year to adjust for interest and inflation, even though the actual cash for the latter is not received until due.
GOVERNMENT AGENCY SECURITIES
30Bonds that are "secured" by a legal claim on the issuer's specific assets in the event of liquidation are called mortgage bonds. Of the large number of corporate bonds outstanding, more than 80 percent have traditionally been rated A or better (based on the value of bonds outstanding).
ASSET-BACKED SECURITIES
ABS and MBS volume declined significantly in 2008 due to the onset of the financial crisis. If the index rises sharply, the investor shares part, but not all, of the gain.
RATES ON FIXED-INCOME SECURITIES
This is not the case for some of the newer loans considered for packaging, such as loans for boats and motorcycles; the smaller amount of information leads to a greater risk of unexpected factors. If the market declines over the life of the note, the option expires worthless, but the investor still has the yield from the zero-coupon bond.
PREFERRED STOCK
5. Municipal bond yields are quoted on an after-tax basis, while corporate bond yields are quoted on a pre-tax basis. Most of the new hybrids are traded on the NYSE, offer fixed monthly or quarterly dividends that are significantly higher than investment-grade corporate bond yields, are rated for credit risk, and have maturities in the 3,049-year range.
COMMON STOCK
The total market value of the company, calculated by multiplying the market price of the stock by the number of shares outstanding, represents the total value of the company as determined in the market. An important question for investors is the value of the distribution, whether a dividend or a split.
INVESTING INTERNATIONALLY IN EQUITIES
These shares are held on deposit in a bank in the issuing company's home country, and the ADRs are issued by American American Depositary Receipts (ADRs) Securities that represent an ownership interest in the shares of foreign companies.
OPTIONS
For example, a seller of a futures contract can buy the contract and cancel the obligation implied by the contract. For example, since the most a buyer of a put or call can lose is the price of the option, the buyer is able to short the distribution of potential returns.
FUTURES CONTRACTS
Investing: A IndirectGlobal Activity
Some of your family or friends own mutual funds and/or ETFs and have been happy with them. Chapter 3, on the other hand, discusses the very important alternative of indirect investing used by many investors - buying and selling mutual funds, closed-end funds, and ETFs.
HOW IMPORTANT ARE INVESTMENT COMPANIES TO INVESTORS?
Organizational structures for investment companies Technically, there are four different types of investment companies: the UIT (unit investment trust), the ETF (exchange traded fund), the closed-end fund and the investment fund (open-end fund). The rationale for emphasizing mutual funds when discussing types of investment companies is evident from Table 3.1, which shows the assets of each of the three major types of investment companies.
CLOSED-END INVESTMENT COMPANIES
In 2008, their shareholders faced large tax bills (for the 2007 tax year) while watching their fund shares fall as the stock market plummeted.14 Note, however, that ETFs can distribute capital gains. Taxpayers faced large tax bills for capital gains distributions even as the value of their trusts' shares declined.
MUTUAL FUNDS (OPEN-END INVESTMENT COMPANIES)
The Growth of Mutual Funds The growth in the number of mutual funds and the assets they hold is an incredible story. 2.Why do you think mutual funds are by far the most popular type of investment company with investors as measured by assets under management.
MONEY MARKET FUNDS
Although investors can assume some risk due to the diversification and quality of these instruments, money market funds are not insured. However, money market funds must invest in fixed income securities with very short maturities, constantly moving over their holdings.
EQUITY FUNDS, BOND FUNDS, AND HYBRID FUNDS
3. Why money market funds are the safest type of mutual fund an investor can hold. The Net Asset Value (NAV) is the value per share of the securities in the fund's portfolio.
CLOSED-END FUNDS
MUTUAL FUNDS
A mutual fund's expense ratio (its annual operating expenses as a percentage of assets) includes any or all of the following (the fund may from time to time waive some of these expenses or charge less than the maximum amount allowed). Expense Ratio The annual charge a mutual fund makes to its shareholders as a percentage of assets under management.
EXCHANGE TRADED FUNDS
Consider load and no-load fund assets as a percentage of total fund assets over the past 20 years or more for both equity and bond funds. For long-term mutual funds, no-load stocks now have twice the net assets that load stocks have.
MEASURES OF FUND PERFORMANCE
Therefore, the average annual total return for a fund shows the compounded annual return at which money grew over time. Average Annual Total Return A hypothetical rate of return used by mutual funds that, if achieved annually, would have produced the same cumulative total return if performance had been constant over the entire period.
MORNINGSTAR RATINGS
In fact, a fund's performance in one year may be negative while shareholders have received large distributions on which they have to pay tax. This includes not only past performance, but also the expense ratio, the fund's investment strategy and other information regarding the fund's manager and parent company.
BENCHMARKS
Ratings take into account both the risk of a fund relative to its category as a whole and its returns, taking the sales charge on a monthly basis. In fact, ratings assess how the fund has balanced return and risk (volatility) in the past.
HOW IMPORTANT ARE EXPENSES IN AFFECTING PERFORMANCE?
SOME CONCLUSIONS ABOUT FUND PERFORMANCE
They study mutual fund rankings and ratings that regularly appear in the popular press. The decline of the dollar in recent years has contributed to the growth of US-reported mutual fund assets in many countries.
FUND CATEGORIES FOR INTERNATIONAL INVESTING
FUND SUPERMARKETS
Matter to All Securities Markets Investors
The structure and operating mechanisms of the securities markets in the United States have changed drastically in the last 10 years. In summary, secondary markets in the United States are indispensable to the proper functioning of the primary markets in which new securities are sold.
THE INVESTMENT BANKER
S. SECURITIES MARKETS FOR THE TRADING OF EQUITIES
Currently, stocks in the United States are traded on two well-known major exchanges: The New York Stock Exchange/Euronext and the NASDAQ Stock Market (NASDAQ). ECNs), a relatively recent innovation for trading securities. The NYSE involves a physical location in New York, while the NASDAQ stock market is an electronic market of traders who make a market in each of the NASDAQ stocks.
THE NEW YORK STOCK EXCHANGE
Listing Requirements The NYSE has specific listing requirements that companies must meet in order to be listed (ie accepted for trading). The NYSE lists a range of companies, including "blue chip" companies as well as younger, high-growth companies.
THE NASDAQ STOCK MARKET
Trading on the NYSE Institutional investors often trade in large blocks, which are defined as transactions involving at least 10,000 shares. Program trading is defined by the NYSE as the purchase or sale of a basket of 15 stocks or more and valued at $1 million or more.
NYSE VS. NASDAQ
THE OVER-THE-COUNTER (OTC) MARKET
BATS
There may be restrictions on the types of orders that can be placed and the size of the orders. Due to the large number of stock markets, both domestic and foreign, there are numerous stock market indicators.
THE DOW JONES AVERAGES
Like any index, the level of the DJIA simply reflects the decisions that have been made about which stocks to include in the index. Therefore, the percentage (rounded) of the decline in the DJIA that day was due to the movement of just one stock in that index.
UNDERSTANDING A CAPITALIZATION-WEIGHTED INDEX
Unlike the DJIA, the composition of the S&P 500 changes several times a year due to acquisitions and mergers and for other reasons. Because it is capitalization weighted, the performance of the S&P 500 Index is significantly influenced by a relatively small number of companies.
NASDAQ INDEXES
In July 2002, the committee at Standard & Poor's, which handles the S&P 500 index, decided that in future foreign companies should no longer be included in the index.
OTHER INDEXES
Finance provides daily, weekly and monthly prices for the major market indices for the start and end dates of your choice.
USING THE CORRECT DOMESTIC STOCK INDEXES
It is designed as a comprehensive measure and represents about 80 percent of the world's stock markets. This section also shows stock market indices for all major foreign markets.
INDIVIDUAL INVESTORS AND BOND TRADING
All FinancialMarkets Have
Now that you know what investment alternatives are available to you, both direct and indirect, and where they are traded, you should consider the details of securities trading as you prepare to invest your inheritance. In this chapter we learn the mechanics of securities trading that investors need to know in order to operate successfully in the market.
BROKERAGE FIRMS
For brokers and investment advisers, a fiduciary standard basically means that the client, as opposed to the interests of the broker or investment adviser, comes first. This magazine is a publication of the American Association of Individual Investors, an organization serving individual investors.
BROKERAGE ACCOUNTS
You carry out the transaction in your regular investment account instead of through a new account with the broker who called. Under this total bill, all fees (the broker-consultant and money manager fees, all transaction fees, custody fees, and the cost of detailed performance reports) are wrapped into one fee.
TRADING ON TODAY ’ S EXCHANGES
Companies that sell stock using this method see it as a way to raise capital without underwriting fees and as a way to build goodwill with investors. Investors can buy or sell Treasuries over the phone or the Internet, and can check account balances, reinvest Treasuries when they mature, and obtain the forms needed to sell Treasuries.
ORDERS IN THE NASDAQ STOCK MARKET
MODERN DAY TRADING
TYPES OF ORDERS
For example, a stop order to sell at $50 becomes a market order to sell as soon as the market price reaches (falls to) $50. EXAMPLE1: A sell stop order can be used to protect a profit in the event of a price drop.
CLEARING PROCEDURES
GOVERNMENT REGULATION
Organized exchanges are required to register with the SEC and agree to be subject to existing law. Two 1940 laws – the Investment Company Act and the Investment Advisors Act – require investment companies and investment advisors to register with the SEC and make certain information public.
SELF-REGULATION
For example, the SEC fined well-known arbitrator Ivan Boesky $100 million in a high-profile insider trading case. The trend is that a higher percentage of those found guilty of insider trading serve prison terms, and the sentences received are longer.
OTHER INVESTOR PROTECTIONS
Links to state regulators can be found at nasaa.org (website for the North American Securities Administrators Association). The bank charges the broker the "broker call rate," and the broker in turn charges the customer a "margin interest rate," which is the broker call rate plus a percentage added by the brokerage firm.18Cash has 100 percent loan value, and most stock securities have 50 percent loan value.
HOW MARGIN ACCOUNTS CAN BE USED
The NYSE requires member firms to establish a minimum deposit of $2,000 or its equivalent in securities for clients opening a margin account, but individual firms may require more simply to open an account. With a margin account, the client can choose to pay part of the total amount owed and borrow the rest from the broker, who in turn typically borrows from a bank to finance clients.
MARGIN REQUIREMENTS AND OBLIGATIONS
Margin Call Amargin call (maintenance call or "house call") occurs when the market value of the margined securities minus the debit balance (amount owed) in the margin account falls below the maintenance requirement set by the brokerage house (typically 30 percent on stocks). Number of shares 1ð Maintenance margin percentageÞ (5-3), where the margin call price is equal to the price of the share that triggers a margin call.
MARGIN REQUIREMENTS ON OTHER SECURITIES
Included are examples of what happens when an investor is on margin, as well as an example of executing a margin call.
SOME MISCONCEPTIONS ABOUT MARGIN
Satisfied with this drop in GM's price, she instructs the broker to buy 100 shares of GM and close the short position. However, if the stock price rises, the short seller will have to put in more money.
SELLING SHORT AS AN INVESTOR
Foundation of Return and Risk: The
Even if you agree that the past is not a sure predictor of the future, it seems reasonable that knowing the history of returns and risks of the major financial assets would be useful. Clearly understand the returns and risk investors have experienced in the past, an important step in estimating future returns and risk.
THE TWO COMPONENTS OF ASSET RETURNS
How would investors have done on average in the past by investing in each of the major asset classes such as stocks and bonds. At the end of the year, this portfolio generated about $19,000 in dividends and interest.
TOTAL RETURN
The table includes year-end values for the index, from which capital gains and losses can be calculated, and dividends on the index, which make up the income component. It is clear that, all other things being equal, TRs in the S&P 500 Index will fall relative to the past due to significant decreases in dividend yields.
RETURN RELATIVE
By one calculation, that one share would have been worth $9.3 million at the end of 2011.
CUMULATIVE WEALTH INDEX
3 Cumulative wealth is always stated in dollars, and represents the effect of compounded returns over a certain period of time, given any initial investment. Example 6-6 Let's calculate cumulative wealth per $1 invested for the 1990s, one of the two largest decades in the 20th century in which common stocks were owned.
INTERNATIONAL RETURNS AND CURRENCY RISK
However, the value of the dollar fell significantly during this period and when EurTel shares were sold, the euro proceeds bought more dollars. By mid-2008 it was worth around $1.56, meaning that the value of the dollar fell significantly throughout this period.
ARITHMETIC MEAN
2. What does it mean to say that when you buy a foreign asset, you are selling the dollar. The total return, relative return, and accumulated wealth index are useful measures of return over a specific period.
GEOMETRIC MEAN
3 Think of the annual geometric mean as the same annual return that causes an initial amount to grow to a certain final amount. 3 The geometric mean will always be less than the arithmetic mean unless the considered values are identical, an unlikely event.
ARITHMETIC MEAN VERSUS GEOMETRIC MEAN
Using the Geometric Mean to Measure Market Performance The geometric mean of the S&P 500 index for. The geometric mean calculation gives the correct annual average price change of 0 percent per year.
INFLATION-ADJUSTED RETURNS
The inflation rate was 3.26 percent. Therefore, the real (inflation-adjusted) total return for large common stocks in 2004, as measured by the S&P 500, was the same. Therefore, the real (inflation-adjusted) geometric mean return for large common stocks for the period 1926-2011 was the same.
SOURCES OF RISK
Interest rate risk The variation in a security's return due to changes in the level of interest rates is referred to as interest rate risk. Market Risk The variation in returns that results from fluctuations in the overall market—that is, the total stock market—is referred to as market risk.
VARIANCE AND STANDARD DEVIATION
The variance and standard deviation are similar and can be used for the same purposes; in particular, both are used as measures of risk in investment analysis. In summary, the standard deviation of return measures the total risk of one security or the total risk of a portfolio of securities.
RISK PREMIUMS
A number of prominent observers have argued that the equity risk premium in the future is likely to be very different from that of the past, notably significantly lower. 7. Why do some market watchers expect the equity risk premium in the future to be much lower than it has been in the past.
TOTAL RETURNS AND STANDARD DEVIATIONS FOR THE MAJOR FINANCIAL ASSETS
3 If we know the arithmetic mean of a series of asset returns and the standard deviation of the series, we can approximate the geometric mean for this series. As the standard deviation of the range increases, while holding the arithmetic mean constant, the geometric mean decreases.
CUMULATIVE WEALTH INDEXES
Small common stocks have by far the greatest volatility of any of the return series considered in Table 6-6. 14On an inflation-adjusted basis, the cumulative final wealth for either series can be calculated as CWIIA¼CWI.
UNDERSTANDING CUMULATIVE WEALTH AS INVESTORS
Universal Theory is Portfolio
We will consider the critically important principle of Markowitz diversification, focusing primarily on the concepts of correlation coefficient and covariance as applied to security returns. For now, it suffices to remind ourselves of the uncertainty of future estimates, a problem that was emphasized at the beginning of Chapter 1.
USING PROBABILITIES
If more things can happen than will happen, and if we are denied precise knowledge of the range of possible outcomes, some of the decisions we make will be wrong. But preparing for the unexpected is a matter of the decision-making structure, and nothing else.
PROBABILITY DISTRIBUTIONS
With the possibility of two or more outcomes, which is the norm for common stock, each possible likely outcome must be considered and the likelihood of its occurrence assessed. The probability for a given outcome is simply the chance that the specified outcome will occur and is usually expressed as a decimal number or a fraction.
CALCULATING EXPECTED RETURN FOR A SECURITY
CALCULATING RISK FOR A SECURITY
