Chapter 11 - Investment Basics

2 basic types of options

- call options - put options

2 basic categories of investments

- lending investments (savings accounts and bonds) - ownership investments (stocks and real estate)

efficient market

A market in which all relevant information about the stock is reflected in the stock price.

primary market

A market in which newly issued, as opposed to previously issued, securities are traded.

over-the-counter market

A market in which transactions are conducted over the telephone or via a computer hookup rather than in an organized exchange.

American Depository Receipt (ADR)

A marketable document (a receipt) that certifies a bank holds shares of a foreign firm's stock that backs the receipt. As a result, the ADR trades just like a normal share of stock.

margin or initial margin

A maximum limit set on the percentage of the purchase price of a security that must initially be paid for by the investor, which is set by the Federal Reserve.

dividend

A payment by a corporation to its shareholders.

margin call

A requirement that you replenish your margin account by adding cash or securities to bring it back to a minimum level.

option

A security that gives its owner the right to buy or sell an asset—generally common stock—at a specified price over a specified period.

seasoned new issue

A stock offering by a company that already has common stock traded in the marketplace.

securities markets

A term used to describe a place where financial securities or instruments—for example, common stocks and bonds—are traded.

day order

A trading order that expires at the end of the trading day during which it was made.

open or good-till-cancelled (GTC) order

A trading order that remains effective until filled or cancelled.

fill-or-kill order

A trading order which if not filled immediately expires.

tenancy-in-common account

A type of joint ownership in which the deceased's portion of the account goes to the heirs of the deceased rather than to the surviving account holder.

joint tenancy account with the right of survivorship

A type of joint ownership in which the surviving owner receives full ownership of the assets in the account when the joint owner dies.

discretionary account

An account that gives your broker the power to make trades for you.

investment

An asset that generates value or a return. For example, stocks pay dividends and bonds pay interest, so these are considered investments.

asset allocation

An attempt to ensure that the investor's strategy reflects his or her investment time horizon and that the investor is well diversified, generally with assets in several different classes of investments, such as domestic common stocks, international common stocks, and bonds.

organized exchange

An exchange that occupies a physical location where trading occurs, such as the New York Stock Exchange.

margin accounts

Securities trading accounts in which the investors borrow a portion of the purchase price from their broker.

cash accounts

Securities trading accounts in which the investors pay in full for their security purchases, with the payment due within 3 business days of the transaction.

derivative securities

Securities whose value is derived from the value of other assets.

financial risk

The risk associated with a company's use of debt. If a company takes on too much debt and can't meet its obligations, the company may default, or the value of its stock may drop.

interest rate risk

The risk of fluctuations in security prices due to changes in the market interest rate.

exchange rate risk

The risk of fluctuations in security prices due to the variability in earnings resulting from changes in exchange rates.

business risk

The risk of fluctuations in security prices resulting from good or bad management decisions or how well or poorly the firm's products are doing in the marketplace.

inflation risk

The risk that rising prices will eat away the purchasing power of your money and that changes in the anticipated level of inflation will result in interest rate changes, which will in turn cause security price fluctuations.

call risk

The risk to bondholders that a bond may be called away from them before maturity.

underwriter

An investment banker who purchases and subsequently resells a new security issue. The issuing company sells its securities directly to the underwriter, who then sells the issue to the public and assumes the risk of selling the new issue at a satisfactory price.

odd lot

An order involving between 1 and 99 shares of stock.

limit order

An order that specifies a securities trade is to be made only at a certain price or better.

market order

An order to buy or sell a set number of securities immediately at the best price available.

stop or stop-loss order

An order to sell a security if the price drops below a specified level or to buy if the price climbs above a specified level.

disposition effect

fearing regret and seeking pride, resulting in selling winners too soon and keeping losers too long.

house money effect

gamblers act differently, taking on risks they wouldn't normally undertake, after making profits on their initial investment

loss then risk aversion effect

investors who lose money are more reluctant to take risks.

online trading

making trades on the Internet.

day traders

Individuals who trade, generally over the Internet, with a very short time horizon, generally less than 1 day.

income return

Investment return received directly from the company or organization in which you've invested, usually in the form of dividends or interest payments.

prospectus

A legal document that describes a securities issue and is made available to potential investors.

discount or online broker

A "no-frills" broker who executes trades without giving any advice and thus charges much lower commission than a full-service broker.

full-service broker or account executive

A broker who gives advice and is paid on commission, where that commission is based on the sales volume generated.

stock

A fractional ownership in a corporation.

portfolio

A group of investments held by an individual.

round lot

A group or lot of 100 shares of common stock. Stocks are traded in round lots on the New York Stock Exchange.

short selling

Borrowing stock from your broker and selling it with an obligation to replace the stock later.

speculation

Buying an asset whose value depends solely on supply and demand, as opposed to being based on the return that it generates. For example, gold coins and baseball cards are worth more in the future only if someone is willing to pay more for them.

nominal (or quoted) rate of return

The rate of return earned on an investment, unadjusted for inflation.

asset management account

Comprehensive financial services package offered by a brokerage firm that can include a checking account; credit and debit cards; a money market mutual fund; loans; automatic payment of fixed debt (such as mortgages or other debt); brokerage services (buying and selling stocks or bonds); and a system for the direct payment of interest, dividends, and proceeds from security sales into the money market mutual fund.

calling a bond

The redeeming of a bond before its scheduled maturity. Many bonds are callable.

churning

Excessive trading in a security account that is inappropriate for the customer and serves only to generate commissions.

market risk

Risk associated with overall market movements.

liquidity risk

Risk associated with the inability to liquidate a security quickly and at a fair market price.

un-systematic or firm-specific or diversifiable risk

Risk or variability that can be eliminated through investor diversification. Unsystematic risk results from factors that are unique to a particular firm.

political and regulatory risk

Risk resulting from unanticipated changes in the tax or legal environment.

systematic or market-related or nondiversifiable risk

That portion of a security's risk or variability that can't be eliminated through investor diversification. This type of variability or risk results from factors that affect all securities.

real rate of return

The current or nominal rate of return minus the inflation rate.

maturity date

The date at which the borrower must repay the loan or borrowed funds.

diversification

The elimination of risk by investing in different assets. It works by allowing the extreme good and bad returns to cancel each other out. The result is that total variability or risk is reduced without affecting expected return.

initial public offering (IPO)

The first time a company's stock is traded publicly.

capital gain or loss

The gain (or loss) on the sale of a capital asset. For example, any return (or loss) from the appreciation (or drop) in value of a share of stock would be considered a capital gain (or loss).

bid price

The highest price someone is willing to pay for a security.

coupon interest rate

The interest to be paid annually on a bond as a percentage of par value, which is specified in the contractual agreement.

ask or offer price

The lowest price at which someone is willing to sell a security.

secondary markets

The markets in which previously issued securities are traded.

investment banker

The middleman between the firm issuing securities and the buying public. This term describes both the firms that specialize in selling securities to the public and the individuals who work for investment banking firms.

maintenance margin

The minimum percentage margin of collateral that you must maintain.

margin requirement

The percentage that an investor must have on deposit with a broker when selling short.

par value or principal

The stated amount on the face of a bond, which the firm is to repay at the maturity date.

herd behavior

When investors see stocks moving one way or the other, they have a tendency to join in and follow the crowd. They look at behavior and assume that it is based on knowledge.