Course 3 Module 10: Formula Investing and Investment Strategies

Which of the following statements is true about a normal yield curve? (Select all that apply) Short-term yield is lower than long-term yield. A portfolio with a bullet strategy is best suited to this environment. A portfolio with a ladder strategy is best suited to this environment. A portfolio with a barbell strategy is best suited to this environment.

1 and 3 A ladder structure will be the most beneficial in a normal upward sloping yield curve indicating higher yield at longer maturities, with a stable interest rate environment. Barbells work better in a flat yield curve while bullet works better for a steep yield curve.

The following is an example of a variable-length moving average strategy:

1. Calculate the average closing price of a given stock over the last 200 trading days. 2. Take today's closing price and divide it by the 200-day average to form a short-to-long price ratio. 3. A ratio greater than 1 is a buy signal that indicates that the stock is to be bought tomorrow. A ratio of less than 1 is a sell signal that indicates that the stock is to be sold tomorrow. 4. Tomorrow after closing, repeat the above process. 5. At the end of a test period, calculate the average daily return during both the "buy" days and the "sell" days.

Technical analysis uses the following methodologies to determine profitable stock selection and market timing opportunities:

1. Charting Strategies involve the examination of historical price patterns, moving average and trading breakout techniques. 2. Sentiment Indicators include contrarian statistics and one of the most accurate of all technical indicators, the Barron's Confidence Index. 3. Flow of Funds Indicators examine the amount of funds that are available to invest. 4. Market Structure Indicators involve looking at the desirability of the overall market and opportunistic entry points.

You have two funds in your portfolio. Their correlation coefficient is 0.5. Fund A has a mean of 10% and a risk of 20%; Fund B has a mean of 8% and a risk of 12%. If your portfolio value consists of 50% of each fund, what is the standard deviation of your portfolio? 18% 12% 14% 16%

14% Simply add the risks (20% + 12% = 32%). Divide by 2 (32% / 2 = 16%). Since the correlation coefficient is less than 1, choose the next lowest answer under 16%. If the correlation coefficient were exactly 1, the portfolio standard deviation would have been exactly 16%.

Use the table above to calculate the return for the dollar-cost averaging investment. 8.18% 4.05% 7.65% 5.98%

8.18% The return for the dollar-cost averaging investment was ($4,327 - $4,000) ÷ $4,000 = 8.175%, or 8.18% (rounded).

The January Effect:

A study that looked at the average monthly returns on NYSE-listed common stocks, found significant seasonalities. In particular, the average return in January was higher than the average return in any other month.

Active Bond Portfolio Management

Active management of a bond portfolio is based on the fact that interest rates change, as well as the belief that the bond market is not perfectly efficient. Such management can involve security selection; that is, the portfolio manager tries to identify mispriced bonds. Alternatively, it can involve market timing; the portfolio manager tries to forecast general movements in interest rates. It is also possible for an active portfolio manager to be involved in both security selection and market timing. Although there are many methods of actively managing a bond portfolio, the manager is generally looking for opportunities created by imbalances between interest rate and price movements in order to lock into some profit before the advantage disappears.

Small Firm Effect:

An investor buys firms that have the ability to generate supernormal growth from quarter to quarter.

What is the beta of the following stock? Standard deviation of the stock is 12%. Standard deviation of the market is 10%. Correlation coefficient of the stock to the market is -0.8. -0.96 0.66 0.80 -0.40

Beta = (Correlation Coefficient x SD of stock) / SD of market Beta = (-0.8 x 12%) / 10% = -0.96 The beta is negative. Can the Beta be negative? Absolutely! Would a client want a stock that had a negative Beta? Yes, it should move opposite the market and reduce volatility his/her portfolio.

Bond portfolio immunization

Bond portfolio immunization is a strategy where a portfolio manager uses a combination of debt securities with varying durations to produce an average duration that meets an investment objective.

Buy and Hold strategy

Buy and Hold is a strategy of buying stock and holding it for a period of years. This method prevents the need to time the market or incur the transaction costs for market timing.

Some active bond portfolio management methods include:

Contingent immunization, Swaps, Caps, Floors, and Collars.

Consider the following case: You invest $250 in stock every month over a period of a year. Which investment strategy are you applying? Buy and Hold Dollar Cost Averaging Dividend Reinvestment Plan All of the above

Dollar Cost Averaging Dollar cost averaging is the practice of purchasing a fixed dollar amount of stock at specified intervals. The logic behind dollar cost averaging is that by investing the same dollar amount each period instead of buying in one lump sum, you'll be averaging out price fluctuations by buying more shares of common stock when the price is lowest, and fewer shares when the price is highest.

Probabilistic Forecasting

Explicit probabilistic forecasting often focuses on economy-wide forecasts. This is because uncertainty at this level is of the greatest importance in determining the risk and expected return of a well-diversified portfolio. A few alternative economic scenarios may be forecast, along with their respective probability of occurrence. Then accompanying projections are made of the prospects for industries, companies, and stock prices. Such exercises often require analysis, sometimes referred to as what-if analysis. These exercises provide an idea of the likely sensitivities of different stocks with respect to the economy. Risks may also be estimated by assigning probabilities to the different scenarios.

Fundamental analysts forecast, among other things, the following:

Future levels of the economy's gross domestic product, Future sales and earnings for a number of industries, and Future sales and earnings for an even larger number of firms.

Bond Swaps

Given a set of predictions about future bond yields, a portfolio manager can estimate holding-period returns over one or more horizons for one or more bonds. The goal of bond swapping is to actively manage a portfolio by exchanging bonds to take advantage of any superior ability to predict such yields. In making a swap, the portfolio manager believes that an overpriced bond is being exchanged for an underpriced bond. Some swaps are based on the belief that the market will correct for its mispricing in a short period of time, whereas other types of swaps are based on a belief that corrections either will never take place or will take place, but over a long period of time.

Active investment strategies include which of the following? I. Dollar cost averaging II. Mutual fund switching III. Market timing IV. Buying an Index fund II, IV I, II, III IV II, III

II, III Dollar cost averaging and buying an Index fund are passive investment strategies.

The following is a list of reasons when considering the buy-and-hold strategy:

It aims at avoiding market timing. By buying and holding the stock, the ups and downs that occur over shorter periods become irrelevant. It minimizes brokerage fees and other transaction costs. Constant buying and selling really racks up the charges, but buying and holding has only the initial purchase charge. By keeping these costs down, the investor retains more of the stock's returns. It helps postpone any capital gains taxes when you are holding and not selling the stock. The longer you can go without paying taxes, the longer you hold your money, and the longer you have to reinvest and earn returns on your returns. It helps your gains to be taxed as long-term capital gains.

What size cap of stock is more suited for passive investment than smaller companies.?

Large cap stocks have a more efficient market (according to the Efficient Market Hypothesis).

Susan Cole, age 28, just inherited $250,000 from her aunt. Susan, a college graduate, is teaching grade school in a small town. She is contributing a small amount each month to a 403(b). At this time, she has no immediate plans to get married and rents a nice apartment. How do you suggest she invest the $250,000 in mutual funds? 50% GNMA, 25% in growth, 25% in tech 50% in high yield corporate bonds, 25% in growth and income, 25% in international 25% in balanced, 25% in growth, 25% in international, 25% in gold 50% in municipal, 50% in natural resources

Muni's will not do her any good, she is in low tax bracket. The two answers with 25% in specialty funds are wrong. You may disagree with the answer, but remember this is strictly a writer's opinion answer. Note: The high yield bonds are not necessarily "junk bonds".

technical vs fundamental analysis

Passive Investing (Indexing) is the strategy of creating a portfolio that mimics a benchmark index. The portfolio manager is not trying to beat the market in this case, but rather trying to earn the same return with the same risk. Technical Analysis uses past data to identify patterns. Momentum investors buy investments that are going up and sell ones that are going down. Contrarians seek dropping securities and sell rising securities. There are also strategies dictating buy and sell decisions based on performance against the high, low and mean price over a previous period.

R squared VS Beta

R-Squared vs. Beta Beta and R-squared are two related, but different, measures of correlation but the beta is a measure of relative riskiness. A mutual fund with a high R-squared correlates highly with a benchmark. If the beta is also high, it may produce higher returns than the benchmark, particularly in bull markets. R-squared measures how closely each change in the price of an asset is correlated to a benchmark. Beta measures how large those price changes are relative to a benchmark. Used together, R-squared and beta give investors a thorough picture of the performance of asset managers. A beta of exactly 1.0 means that the risk (volatility) of the asset is identical to that of its benchmark. Essentially, R-squared is a statistical analysis technique for the practical use and trustworthiness of betas of securities.

Neglected Firm Effect:

Stocks that are not followed by any (or very few) analysts have been shown to generate superior performance.

Low P/E Effect:

Stocks that have low price-to-earnings ratios (the so-called value stocks) outperform all other types of stocks (including growth stocks) over the business cycle.

The Day-of-the-Week Effect:

Studies that looked at the average daily return on NYSE-listed securities found that the return on Monday was quite different from returns on other days. In particular, the average return on Monday was found to be much lower than the average return on any other day of the week.

Which of the following is not a passive asset allocation technique? Laddered bonds Indexed portfolios Advance / decline line Dollar-cost-average

The advance / decline line is a technical indicator. Technical indicators are active not passive.

For example, a passive manager might only have to choose the appropriate mixture of Treasury bills and an index fund that is a surrogate for the market portfolio. The optimal mixture is only changed when:

The client's preference changes The risk-free rate changes The consensus forecast about the risk and return of the benchmark portfolio changes The manager must continue to monitor the last two variables and keep in touch with the client concerning the first one. No additional activity is required.

Top-Down:

The financial analysts are first involved in making forecasts for the economy, then for industries, and finally for companies.

Bottom-Up:

The financial analysts begin with estimates of the prospects for companies and then build to estimates of the prospects for industries and ultimately the economy.

"Head and Shoulders Reversal Pattern" or "Head and Shoulders Top."

The first image shown below is an example of a "Head and Shoulders Reversal Pattern" or "Head and Shoulders Top." Notice how the pattern contains three successive peaks, with the middle peak (know as the "head") being the highest and the two outside peaks (knows as the "shoulders") being low and roughly equal. The reaction lows of each peak can be connected to form a "neckline." A head and shoulders reversal pattern forms after an uptrend, and its completion marks a trend reversal. A technician would view this price pattern as a distinct sell signal. Head and Shoulders Top has three successive peaks, forms after an uptrend, and is viewed as a sell signal.

Portfolio Immunization

The introduction of the concept of duration led to the development of the technique of bond portfolio management known as immunization. Specifically, this technique purportedly allows a bond portfolio manager to be relatively certain of being able to meet a given promised stream of cash outflows. Thus, once the portfolio has been formed, it is "immunized" from any adverse effects associated with future changes in interest rates.

Trading Range Breakout Strategy

The trading range breakout strategy is similar to the fixed-length moving average strategy. Here the high and low prices over the past 200 trading days are noted. A buy signal is generated on a given day only when that day's closing price is greater than the high, provided that the previous day's closing price was less than the high. Conversely, a sell signal arises when the closing price moves from being above the low on one day to being below the low on the next day. When a buy signal is generated, the stock is repurchased the next day and then held for ten days. Similarly, when a sell signal is generated, the stock is sold and not bought for ten days. In either case, when the ten days are over, the investor starts looking again for a buy or a sell signal. A study examined this strategy using daily data from 1897 to 1986, a total of over 25,000 trading days. The daily closing level of the Dow Jones Industrial Average (DJIA) was used instead of daily closing prices for individual stocks. The following table presents its data:

Barron's Confidence Index (BCI)

The weekly newspaper Barron's publishes this figure, the Barron's Confidence Index (BCI) every week in the laboratory section. The index shows the relationship between the yield on high quality corporate bonds and the yield on average quality bonds. The average yield on the high quality bonds is divided by the average yield on the average quality bonds.

Intermarket spread swap

This swap involves a more general movement out of one market component and into another with the intention of exploiting a currently advantageous yield relationship. The idea here is to benefit from a forecasted changing relationship between the two market components. Note: All bonds "swaps" are taxable events, i.e. a sale and a purchase.

Substitution swap

This swap is an exchange of a bond for a perfect substitute or "twin" bond. The motivation here is temporary price advantage, presumably resulting from an imbalance in the relative supply and demand conditions in the marketplace.

Rate anticipation swap

This swap is geared toward profiting from an anticipated movement in overall market rates. Note: All bonds "swaps" are taxable events, i.e. a sale and a purchase.

Pure yield pickup swap

This swap is oriented toward yield improvements over the long term, with little heed being paid to interim price movements in either the respective market components or the market as a whole. Note: All bonds "swaps" are taxable events, i.e. a sale and a purchase.

Default or Call Risk -

To begin with, immunization (and duration) are based on the assumptions that the bonds will not default and will not be called before maturity; that is, the bonds are assumed to be free from both call risk and default risk and will thus pay their promised cash flows in full and on time. Consequently, if a bond in the portfolio either enters into default or is called, the portfolio will not be immunized.

Point and figure charting

Type of technical analysis. The idea is that charts created based on historical data are laid out in front of the analyst. He or she will point to the incidences where a certain pattern occurs and mark them down. The result is a chart that is marked with reoccurring incidences based on criterion such as moving average or trading range breakouts.

Y or N: Was technical analysis significant for this period?

Yes. If the market was efficient, the difference between the returns should be approximately zero. Since all three methods yield significant differences between buy day and sell day returns, it can be said that technical analysis would have made a difference during this period.

An interest rate cap is

an agreement by one party to make payments to another party when interest rates rise above a certain level or "cap." For example, an issuer may purchase a cap to insure against spikes in variable rates for one year. If interest rates rise above the cap level during that time, the issuer will receive the difference between the actual market and the cap level.

A bullet-structured portfolio

benefits when the yield curve is expected to steepen. A bullet structure usually weighs heavier around intermediate term assets. A bulleted maturity tends to outperform a barbell structure when the yield curve steepens because in a rising rate environment, intermediate-term securities usually hold up better than long-term securities. Also, in a declining interest-rate environment, intermediate securities produce significantly greater price appreciation than do short-term securities. Those investors who anticipate the yield curve to become steeper will use a bullet strategy.

A fixed-length moving average strategy

can reduce the frequency of changing positions from buying to selling, or from selling to buying. Buy signals are now generated only when the ratio changes from <1 to >1, and sell signals are generated when the ratio changes from >1 to <1. When a buy signal is generated, the stock is bought the next day and held for ten days. Similarly, when a sell signal is generated, the stock is sold and not bought for ten days. In either case, when the ten days are over, the investor starts looking again for a buy or a sell signal. Whereas the variable-length strategy classified every day as either a buy or a sell day, there can be days that are not classified as either buy or sell with the fixed-length strategy.

A ladder structure

is a portfolio of bonds that mature at regular intervals throughout the various maturities of the yield curve. To perpetuate a ladder structure, as each bond matures, the proceeds are used to purchase a bond that will mature at the next interval after the one with the longest maturity in the portfolio. Ladders are most effective when the yield is normal or sloping upward and interest rates are fairly stable. Ladders are typically constructed using U.S. Treasuries or even CDs at a local bank. Those who are neutral or uncertain will buy a ladder.

An econometric model is

is a statistical model. This model provides a means of forecasting the levels of certain variables, known as endogenous variables. In order to make these forecasts, the model relies on assumptions that have been made in regard to the levels of certain other variables supplied by the model user, known as exogenous variables. For example, the level of new homes projected to be built next year is a derivative of the level of GDP and interest rates. Therefore, the endogenous variable of housing starts is dependent of the exogenous variables of the GDP and interest rates.

A barbell

is a strategy of holding more bonds at the short and long end of the yield curve with intermediate bonds being underweighted. This allows a portfolio's price to match the volatility of an intermediate-term liability. When there is a likelihood that the Federal Reserve will loosen monetary policy in the near term, a barbelled portfolio may increase a bond portfolio's return. Those who expect the yield cure to flatten will pick the barbell.

The Dow Theory has three trends:

major trends, intermediate trends, and short-term run movements. Technicians will look for reversals and recoveries in major market trends. Price alone does not tell the story. Market sentiment and changes in supply and demand (volume) are factored in as well. In general, when the following ratio (volume of stocks that have increased / volume of stocks that have decreased) is 1.50 or more, it indicates a bearish sign. When the ratio is 0.75 or lower is a bullish sign. Conversely, if either the industrials or transportations make new annual lows, and the other index (the transportations or industrials) confirm with new lows as well, a sell signal is created. If one of the indices makes new lows, and the other index does not confirm with lows of its own, a state of divergence occurs and neither a sell signal nor a buy signal occurs.

Open-ended mutual funds will also accommodate

reinvestment of dividends. As long as your fund pays dividends, it can be reinvested back into your account to buy additional shares. Again, unless the mutual fund is held in a tax-deferred retirement account such as an IRA, the amount of dividends will be taxable as income.

Efficient markets are

those markets for securities in which every security's price equals its investment value at all times, implying that a specified set of information is fully and immediately reflected in market prices. To test for market efficiency is to investigate whether there are any patterns in security price movements attributable to something other than what one would expect. In recent years, a large number of these patterns have been identified and labeled as empirical regularities or market anomalies.

"Inverse Head and Shoulders Pattern" or "Head and Shoulders Bottom."

three successive troughs, forms after a downtrend, and is viewed as a buy signal.

The yield differential between the high quality and average quality bonds

widens (or is wide) in a bearish economy. This is true when the index is falling or is low. Conversely, in a bullish economy, the yield differential is narrowing (or is narrow), and will cause the index to be high.

Market Timing

"Buy low, sell high." This sentiment is the epitome of market timing. The strategy is simply trying to buy securities when the market is down and sell them when the market is high. A market-timer structures a portfolio to have a relatively high beta when he expects the market to rise and a relatively low beta when a market drop is anticipated. In other words, a market timer will: Hold a high-beta portfolio when Expected Market Return > Risk-free Return, and Hold a low-beta portfolio when Expected Market Return < Risk-free Return. If the timer is accurate in his forecast of the expected return on the market, then his portfolio will outperform a benchmark portfolio that has a constant beta equal to the average beta of the timer's portfolio. However, forecasting the market return is the hard part. The actual result will be determined by the accuracy of his or her forecast regarding the relationship between the market's return versus a risk-free return. To "time the market," one must change either the average beta of the risky securities held in the portfolio or the relative amounts invested in the risk free assets and risky securities. For example, selling bonds or low-beta stocks and using the proceeds to purchase high-beta stocks could increase the beta of a portfolio. Alternatively, Treasury bills in the portfolio could be sold, with proceeds being invested in stocks or stock index futures. Because of the relative ease of buying and selling derivative instruments such as stock index futures, most investment organizations specializing in market timing prefer the latter approach. CASE-IN-POINT: Remember, having a high beta does not necessarily mean that the portfolio will behave like the market. R-squared (coefficient of determination) should also be checked to determine how closely correlated the portfolio is to the market.

How would you position $150,000 using the "barbell" strategy? $62,500 in short-term maturities, $25,000 in intermediate maturities and $62,500 in long-term maturities. $50,000 in short-term maturities, $50,000 in intermediate maturities and $50,000 in long-term maturities. $150,000 in long-term maturities, reposition yearly. $75,000 in short-term maturities, $75,000 in long-term maturities.

$75,000 in short-term maturities, $75,000 in long-term maturities. When using the barbell strategy, the investor acquires a portfolio of very long-term and very short-term maturities.

Dollar cost averaging is a risk reduction method that would lower risk and likely increase return. Which of the following market conditions would be the LEAST favorable for dollar cost averaging? Stock price is on the rise Stock price is dropping Stock price is level Stock price is fluctuating

1. Dollar cost averaging can help investors lower their overall average cost per share in most market conditions except for when the stock price is continuously increasing. In that case, the investor would have been better off investing everything at the lower price in the beginning.

Margaret has two bond types in a portfolio. Forty percent of the portfolio is in a zero coupon bond which will mature in 10 years. The other sixty percent is invested in a 30-year bond with a duration of 27. What is the average duration of this portfolio? 27 20.2 37 10.1

20.2 Zero coupon bonds have a duration that equals its maturity. (40%)(10)+(60%)(27) = 20.2

Which of the following interest rate environments are beneficial for the buyer of a collar? Rates go above cap Rates remain between cap and floor Rates go below floor

A collar is beneficial when the rate goes above the cap.

Charting

Charting refers to the plotting prices of securities over time. Moving averages, trading ranges, and pattern formations are all based on this technique. Even though technicians utilize dozens and dozens of historic price patterns, in this lesson we will discuss the two best known technical indicators of future security price movement - the "Head and Shoulders Pattern" and the "Inverted Head and Shoulders Pattern."

One of the oldest and most reliable market structure indicators is the

Dow Theory. Invented by Charles Dow in the late 1890s, the theory has to do with the Dow Industrial Index and the Dow Transportation Index. The theory has nothing to do with the Dow Utility Index.

Your client read an article about Dow Theory and asks you to explain its basic elements. Which of the following will you tell your client about the Dow Theory? I. Dow Theory reflects a passive strategy that is supported by Modern Portfolio Theory. II. Dow Theory indicates an active strategy that is not supported by Modern Portfolio Theory. III. Dow theory factors price action, support and resistance levels, stock values, confirmations, and divergences. IV. Dow Theory focuses on the Dow Jones Industrials Index. V. Dow Theory focuses on the Dow Jones Transportation Index. II, III, IV II, III, IV, V I, III, IV I, III, IV, V

II, III, IV, V Dow Theory contradicts Modern Portfolio Theory and the Efficient Market Hypothesis. Technical analysis is an active strategy. Dow Theory is concerned with price movements and volume. Support levels are price ranges where an increased demand for a stock pushes up price and volume; resistance levels are price ranges where a decrease in demand (and an increase in supply) for a stock reverses a preceding price increase. Charles Dow examined two indices to chart the market's direction: The Dow Jones Industrial Index and the Dow Jones Rail Index (now the Transportation Index). These two indices indicate technical confirmations or divergences of the primary market trend. A confirmation indicates the major trend is (still) in place; a divergence indicates the major trend may be changing or already has changed.

Dividend Reinvesting

If you want to use common stock to accumulate wealth, you must reinvest rather than spend your dividends. Under a dividend reinvestment plan (DRIP), you are allowed to reinvest the dividend in the company's stock automatically without paying any brokerage fees. Most large companies offer such plans, and many stockholders take advantage of them.

Multiple Nonparallel Shifts in a Non-horizontal Yield Curve

Immunization (and duration) are also based on the assumption that the yield curve is horizontal and that any shifts in it will be parallel and will occur before any payments are received from the bonds that were purchased. In reality, the yield curve will not be horizontal at the start, and shifts in it are not likely to be either parallel or restricted when they occur. Indeed, there is evidence of greater volatility in yields of shorter-term securities. If these kinds of shifts occur, then it is possible that the portfolio will not be immunized.

How To Immunize

Immunization is accomplished by calculating the duration of the promised outflows and then investing in a portfolio of bonds that has an identical duration. In doing so, this technique takes advantage of the observation that the duration of a portfolio of bonds is equal to the weighted average of the durations of the individual bonds in the portfolio. For example, if a portfolio has one-third of its funds invested in bonds with a duration of six years and two-thirds in bonds having a duration of three years, then the portfolio itself has a duration of four years: (1/3)(6) + (2/3)(3) = 4. To immunize a bond portfolio, money managers will match the duration of the portfolio with the investor's time horizon. Passive managers will only match the duration once. Active managers will monitor and trade bonds to ensure that the duration remains consistent with the investor's time horizon on an ongoing basis. The key is that the manager's adjustments are based on the duration and not the maturity of the fixed income securities.

A technician will always react in ways contrary to these particular indicators.

Odd Lot Activity: An odd lot is a trade that takes place for an amount of shares that is less than 100. When the net activity of odd lot orders is for purchases, this will be a sell signal for a technician. When the net odd lot activity is for sale orders, this will be viewed as a buy signal. For the most part, small, non-institutional investors initiate these odd lots. The view on Wall Street is that the large institutional investors represent the so-called smart money, and that the small independent individual investor will always time the general market direction incorrectly. Short Sale Interest: Every month, the financial newspapers publish the amount of open interest of stocks that have been sold short. When short selling reaches record levels (or even high levels) that will be viewed as an extremely bullish signal. You may be tempted to think that many investors have short stock positions, so therefore stock prices must be headed lower. Actually, since short selling represents a contractual obligation to buy back the underlying securities, this represents a certain demand for those securities. Therefore a technician would view record levels of short selling as a very bullish signal. Investment Advisors Bullish/Bearish Index: Periodically, professional investment advisors are polled in order to obtain their opinions as to where the major market indices will be in a year. If more than 50% of the advisors polled are bullish, that will be a sell signal for a technician. If more than 50% of the advisors polled are bearish, that will be a buy signal. The irony is that professional investment advisors do not seem to know any more than small, independent investors!

Flow of Funds Indicators

One high level indicator of funds flow is the funds flowing in or out of mutual funds. Another closely related statistic is the percentage of cash (that has yet to be invested) contained in the average mutual fund. A net fund inflow into equity funds, as well as lower cash levels in mutual funds are bullish indicators for the stock market. An indicator that is often used for individual securities is the Money Flow Index (MFI). The MFI is a momentum indicator that is very rigid in that it is volume-weighted, and is therefore a good measure of the strength of money flowing in and out of a security. It compares "positive money flow" to "negative money flow" to create an indicator that can be compared to price in order to identify the strength or weakness of a trend. The MFI is measured on a 0-100 scale and is often calculated using a 14-day period. The "flow" of money is the product of price and volume and shows the demand for a security and a certain price. The money flow is not the same as the Money Flow Index but rather is a component of calculating it. When calculating the money flow, we first need to find the average price for a given period. Since we are often looking at a 14-day period, we will calculate the typical price for a day and use that to create a 14-day average. The MFI compares the ratio of "positive" money flow and "negative" money flow. If typical price today is greater than yesterday, it is considered positive money. For a 14-day average, the sum of all positive money for those 14 days is the positive money flow. The MFI is based on the ratio of positive/negative money flow (Money Ratio). The fewer number of days used to calculate the MFI, the more volatile it will be.

Contingent Immunization

One method of bond portfolio management that has both passive and active elements is contingent immunization. In the simplest form of contingent immunization, the portfolio will be actively managed as long as favorable results are obtained. However, if unfavorable results occur, then the portfolio will be immunized immediately.

Fundamental analysis

One of the major divisions in the ranks of financial analysts is between those using fundamental analysis and those using technical analysis. Fundamental analysis looks at the fundamentals of the business, which are best disclosed on the financial statements, the balance sheet and the income statement. The fundamentalist tends to look forward and the technician backward. The fundamentalist is concerned with matters such as future earnings and dividends. Although many investors use technical analysis, fundamental analysis is far more prevalent. Furthermore, unlike technical analysis, fundamental analysis is an essential activity if capital markets are to be efficient.

Which of the following would describe a contrarian investor? (Select all that apply) Buys securities that are doing well Sells securities that are doing well Buys securities that are doing poorly Sells securities that are doing poorly

Sells securities that are doing well Buys securities that are doing poorly Contrarians invest in a manner that is completely opposite to momentum investors. They tend to buy stocks that have had recent bad news and sell the ones that have recently performed well.

Sentiment Indicators

Since economic activity has been highly correlated to investor and consumer behavior, the sentiment indicators have emerged as being extremely important. These psychological indicators attempt to measure the degree of bullishness or bearishness in a market. The first group we will examine are known as contrarian indicators. They are called contrarian, due to the fact that the technician will react in a way that may seem "contrary" to the particular indicator. Then we will describe the Barron's Confidence Index, which is perhaps the most important sentiment indicator. This is because this indicator serves as an extremely reliable measure to gauge economic turning points.

Technical Analysis

Technical analysis is the study of the internal stock exchange information. The word technical implies a study of the market itself, the "push" and "pull" of supply and demand forces on the market. Technical analysts track market statistics such as price levels and the trade volume in the exchanges. The technician usually attempts to predict short-term price movements and thus makes recommendations concerning the timing of purchases and sales of either specific stocks, groups of stocks (such as industries), or stocks in general. The methodology of technical analysis rests upon the assumption that history tends to repeat itself in the stock exchange. Thus, technicians assert that the study of past patterns of variables such as prices and volumes will allow the investor to accurately identify times when certain specific stocks (or groups of stocks, or the market in general) are either overpriced or under priced. Most, but not all, technical analysts rely on charts of stock prices and trading volumes. Technical analysts are not concerned with the fundamental prospects of a firm. In fact, what the company does, what they make, their relative market share, etc., is all unimportant information according to a technician. The company's recent price action relative to volume and volume reversals are the only things that matter. It is important to note that proponents of any form of the Efficient Market Hypothesis (EMH) do not recognize technical analysis as adding any value to security selection. Likewise, technicians do not believe the EMH to be valid.

Value Line Phenomenon:

The Value Line Investment Survey is stock research that is available through subscriptions. The service ranks 1,700 widely held securities according to their projected performance over a 6-12 month period. Since the mid-1960s, the Value Line portfolio of stocks ranked 1 have outperformed the S&P 500 Index 17 fold! This statistic does not include taxes and transaction costs.

Your client owns a stock fund in a joint account with his wife. He elected to have the distributed dividends and capital gains reinvested back into the fund. Which of the following statements are true? (Select all that apply) The reinvestments will have a dollar cost average effect on the account. Since he did not take the dividends and distributed capital gains as cash, he will not need to pay taxes on them. The reinvested amounts will not affect the cost basis of the account. The reinvested amounts will purchase additional shares.

The reinvestments will have a dollar cost average effect on the account. The reinvested amounts will purchase additional shares. Reinvestment of dividends and distributed capital gains is a method to purchase additional shares rather than taking the amounts as cash. Since it is a purchase on a regular basis, it is gives the effect of dollar cost averaging. The cost basis of the account will change because the additional shares will be purchased at different share prices. Although the client does not take the money out of the account, the dividends and distributed gains are still taxable.

DRIPs have several drawbacks, including:

When you sell your stock, you'll have to figure your cost basis for your dividends that are reinvested (most brokerage firms do this automatically for clients). In addition, you will pay income tax on the reinvested amounts as if you actually received these dividends. You can't choose what to do with your own dividend. For example, if the company you've invested in is performing moderately well, and you just heard about another company whose stock price is rising faster. You are stuck reinvesting instead of trying something new.

An interest rate floor is

an agreement by one party to make payments to another party when interest rates fall below a certain level or "floor." This is analogous to receiving the present value of the expected floating rate benefit for the term of the floor. Floors can reduce the initial cost of the financing by generating current income. However, they limit the benefits of variable rate exposure without reducing the risk.

Active managers

believe that from time to time there are mispriced securities or groups of securities. They do not act as if they believe that security markets are efficient. Put somewhat differently, they use deviant predictions; that is, their forecasts of risks and expected returns differ from consensus opinions.

An interest rate collar is

essentially the combination of a cap and a floor. An issuer that wants to limit variable rate exposure will simultaneously purchase a cap and sell a floor. Interest rate collars provide protection against rising rates while limiting the benefits of declines in rates. Collars can finance themselves: the cost of the cap can be offset by the proceeds from the sale of the floor. Despite relatively inefficient pricing, a collar may be desirable for a pilot variable-rate program until the issuer has a good sense of where its short-term debt will trade in the market.

An econometric model may be

extremely complex or it may be a very simple formula. In either case, it involves a blend of economics and statistics. Economics is first used to suggest the forms of relevant relationships and then statistical procedures are applied to historical data to estimate the exact nature of the relationships involved.

Passive managers

generally act as if the security markets are relatively efficient. Put somewhat differently, their decisions are consistent with the acceptance of consensus estimates of risk and return. The portfolios they hold may be surrogates for the market portfolio, known as index funds, or they may be portfolios that are tailored to suit clients with preferences and circumstances that differ from those of the average investor. In either case, passive portfolio managers do not try to outperform their designated benchmarks.

The only instance where dollar cost averaging will not work is

if the stock or stock fund's price continues to rise and never drops. If that was the case and your client had a lump sum to invest, it would have been cheaper to buy it in the beginning. While in the short-term this may occur, it is very unlikely for a security to never fluctuate downwards as well as upwards over the long-term. Therefore, dollar cost averaging will still have its merit. However, it should be noted the greatest benefit to the strategy is to teach your clients to be disciplined investors.

In times of economic distress, investors behave

in a way that is known as "a flight to quality." They will sell instruments with marginal quality, opting for high quality investments. This selling pressure of the lower quality instruments will drive prices down and the yield higher. Also, the buying demand for the high quality instruments will drive prices up and those yields lower. This means that the index will fall in value in a bearish economy. When economic prospects begin to brighten, investors prefer to sell their high quality instruments in favor of lower quality investments in order to enhance their income yield. That activity will drive up the yield on the high quality bonds, while lowering the yield on the lower quality bonds. The index from this activity will rise.