Chapters 14, 15, and 17
Common investment mistakes
- Making Decisions Based on Unrealistic Goals - Borrowing to Invest - Taking Risks to Recover Losses
Bonds are:
- long-term debt securities issued by government agencies or corporations. - coupon payments and bond price appreciation.
Investment returns: stock
-Returns come through dividends and price appreciation -Growth stocks: stocks of firms with substantial growth opportunities -Income stocks: stocks that provide investors with periodic income in the form of large dividends
Mutual Funds
-Sell shares to individuals and invest the proceeds in a portfolio of investments -Publicly traded indexes: securities whose values move in tandem with a particular stock index representing a set of stocks ▪One of the most popular is the Standard & Poor's Depository Receipt (S.P.D.R, also called Spider)
Short selling stock
-Short selling (shorting): a process by which investors sell a stock that they do not own -Borrow stock from another investor and will have to return it -Investor hopefully sells high and buys low (in that order)
Return-risk trade-off among stocks
-Small firms tend to have more growth potential, but higher risk -IPOs may offer high returns, but also have high risk, especially for individual investors
Motives for investing in mutual funds:
-Small initial investment with immediate diversification benefits -Expertise of portfolio manager -To meet specific investment goals
Disadvantages of ETFs
-Some are thinly traded -You pay a brokerage fee every time you buy additional ETF shares
Other stock exchanges
-The NYSE American LLC ▪Focuses on trading smaller firm and ETFs ▪Formerly known as the American Stock Exchange (AMEX) -Other regional exchanges in large U.S. cities ▪Regional exchanges have less stringent listing requirements
NASDAQ Stock Market
-The other major U.S. stock market -Trades 1.8 billion shares per day -More than 3,000 firms listed -More small firms than the NYSE listed
Advantages of ETFs
-Typically have lower expense ratios since most are passive management funds -No loads on ETFs -Often more tax efficient
Risk from investing
-can be like gambling -Range of returns: returns of a specific investment over a given period -Standard deviation: the degree of volatility in the stock's return over time -Subjective measures of risk ▪Bond rating agencies are one example where investors can assess risk based on the firm's bond rating AAA-CC
Open-end mutual funds
-funds that sell shares directly to investors and repurchase those shares whenever investors wish to sell them ▪Usually managed by investment companies that are subsidiaries of a large financial conglomerate ▪Family: a group of separately managed open-end mutual funds held by one investment company
Closed-end mutual funds
-funds that sell shares to investors but do not repurchase them; instead fund shares are purchased and sold on stock exchanges ▪Premium: the amount by which a closed-end fund's share price in the secondary market is above the fund's NAV ▪Discount: the amount by which a closed-end fund's share price in the secondary market is below the fund's NAV
Stop order
an order to execute a transaction when the stock price reaches a specified level; a special form of limit order ▪Buy stop order: when the price rises to a specified level ▪Sell stop order: when the price falls to a specified level
The expense ratio for a fund is:
annual expenses per share/asset value per share
A round lot is an order for:
shares of stock sold in multiples of 100
Tax on Short Term Capital Gain formula
short term capital gain * marginal income tax rate (decimal)
Investors purchase load funds because:
they believe that the load fund will generate higher returns and outperform a no-load fund even after the load fee.
Margin sales benefit the brokerage firm because:
they earn interest.
Floor traders
traders at a stock exchange who execute trades to fulfill orders placed by other investors (15% of trades)
Specialists
traders who help to make a market in one or more stocks by taking the position opposite of orders placed by clients
Diversification through mutual fund supermarkets
an arrangement offered by some brokerage firms that enables investors to diversify among various mutual funds (from different mutual fund families) and to receive a summary statement for these funds on a consolidated basis
Over-the-counter (OTC) market:
an electronic communications network that allows investors to buy or sell securities -Less stringent listing requirements than for NYSE -More than 10,000 small firms traded on the OTC
Investment returns: real estate
-Rental income and price appreciation
Return-risk trade-off among real estate
-Renters could default -Property value could decline
How your wealth is influenced by your return
-Any return saved increases the value of assets and therefore increases wealth -Future value calculations can help estimate these increases
Analyzing a firm's financial condition
-Balance sheet: a financial statement that indicates a firm's sources of funds and how it has invested its funds as of a particular point in time -Income statement: a financial statement that measures a firm's revenues, expenses, and earnings over a particular period of time
Investment returns: mutual funds
-Can generate a capital gain and shares may increase in value
Stocks
-Common versus preferred stock ▪Common stock: a certificate issued by a firm to raise funds that represents partial ownership in the firm ▪Preferred stock: a certificate issued by a firm to raise funds that entitles shareholders to first priority to receive dividends
Tradeoff between expected return and risk of bond funds
-Conservative—short-term Treasury bond fund ▪No default risk and limited interest rate risk ▪Low return -Moderate—Ginnie Mae bond fund ▪Slight default risk and moderate interest rate risk ▪Moderate return -High risk—junk bond fund ▪High default risk and high interest rate risk ▪Potentially high return
Limitation of stock analysis
-Difficulty in forecasting future conditions -Favorable attributes are reflected in the stock price ▪Difficult to identify undervalued stocks before they increase in price
Analyzing economic conditions for stock evaluations
-Economic growth: a measure of growth in a country's economy over a particular period -Gross domestic product (GDP): the total market value of all products and services produced in a country -Fiscal policy: the means by which the U.S. government imposes taxes on individuals and corporations and by which it spends its money -Impact of international economies ▪One country's strong economy can improve another's and the opposite is also true -Inflation: the increase in the general level of prices of products and services over a specified period (CPI and PPI)
Types of investors
-Institutional investors: professionals responsible for managing money on behalf of the clients they serve -Portfolio managers: employees of financial institutions who make investment decisions -Individual investors: individuals who invest funds in securities -Day traders: investors who buy stocks and then sell them on the same day
Risk from investing in a bond mutual fund
-Interest rate risk: for a bond mutual fund, its susceptibility to interest rate movements -Longer-term bonds most sensitive -Must also consider default risk -Bond funds can have either interest rate risk, default risk, or both
Reviewing a mutual fund's prospectus
-Investment objective: in a prospectus, a brief statement about the general goal of the mutual fund -Investment strategy: in a prospectus, a summary of the types of securities that are purchased by the mutual fund in order to achieve its objective -Past performance—1 year, 3 years, 5 years ▪Performance is normally compared to a market index such as the S&P 500 for a stock fund -Fees and Expenses ▪Maximum load ▪Redemption fee or back-end load ▪Expenses, including management fees -Risk -Distribution of dividends and capital gains -Minimum investment and minimum balance -How to buy or redeem shares
Return-risk trade-off among bonds
-Large, well-known firms have low return, low risk -High-risk bonds offer higher payments
Mutual funds: Lipper indexes
-Lipper indexes are useful for assessing the recent performance of a particular fund or funds with a specific objective
Bonds
-Long-term debt securities issued by government agencies or corporations
Risk from investing in a stock mutual fund
-Market risk: the susceptibility of a mutual fund's performance to general stock market conditions Trade-off between expected return and risk of stock funds: -Conservative—stock index fund (Limited return and risk) -Moderate—growth stock fund (Moderate return and risk) -High risk—growth stock fund in one sector (High return and risk)
NYSE (New York Stock Exchange)
-Most popular organized exchange in U.S. -About 85% of trades now done electronically -Handles transactions for about 2,800 stocks -Trades 1.5 billion shares per day -A typical stock transaction on the N Y S E is submitted through a brokerage firm and executed by a specialist
Return-risk trade-off among mutual funds
-Mutual funds containing small stocks are more risky than those containing large stocks -Mutual funds containing bonds of weak corporations are more risky than those with bonds of creditworthy corporations
Load vs no-load funds
-No-load mutual funds: funds that sell directly to investors and do not charge a fee -Load mutual funds: funds whose shares are sold by a stockbroker who charges a fee (or load) for the transaction -Loads can have significant impact on investment performance
Buying stock on margin
-On margin: purchasing a stock with a portion of the funds borrowed from a brokerage firm -Federal Reserve limits margin to 50 percent -Margin call: a request from a brokerage firm for the investor to increase the cash in the account in order to bring the margin back up to the minimum level
Stock Markets
-Primary and secondary stock markets -Primary market: a market where newly issued securities are traded ▪Initial public offering (IPO): the first offering of a firm's stock to the public -Secondary market: a market where existing stocks are traded
Balanced growth and income funds:
-mutual funds that contain both growth stocks and stocks that pay high dividends
Sector funds
-mutual funds that focus on a specific industry or sector, such as technology stocks ▪Technology funds: mutual funds that focus on stocks of technology-based firms and therefore represent a particular type of sector fund -Index funds: mutual funds that attempt to mirror the movements of an existing stock index
International bond funds
-mutual funds that focus on bonds issued by non-U.S. firms or governments ▪Exchange rate risk: risk realized when the value of a bond drops because the currency denominating the bond weakens against the dollar
Market Makers
-traders who execute trades on the OTC market and earn commissions in the form of a bid-ask spread
Secondary market
A market where existing securities are traded
Short selling (shorting)
A process by which an investor sells stock that they do not own
market order
An order to buy or sell stock at its prevailing market price
Limit order
An order to buy or sell stock only if it is within the price limits that you specify
All bonds are subject to ____ risk.
All bonds are subject to interest rate risk.
Ticker symbol
An abbreviated term that is used to identify a stock
Some characteristics to consider when picking a broker are:
Analyst recommendations ▪May be overly optimistic ▪Must disclose ownership of stocks they recommend Individual broker skills ▪Information available on the Internet Brokerage commissions ▪Discount brokerage firm: a brokerage firm that executes your desired transactions but does not offer investment advice ▪Full-service brokerage firm: a brokerage firm that offers investment advice and executes transactions
Long-term capital gain
A long-term gain is a gain on assets held for more than 12 months and is usually taxed at a lower rate than short-term gains. For 2016, the long-term capital gains tax rate was 0% (for marginal tax brackets of 10% and 15%) and 15% (for marginal tax brackets of 25% and above).
Short-term capital gain
A short-term gain is a gain on assets held for 12 months or less and is taxed at an investor's marginal (ordinary) tax rate as if it were additional income.
On margin
Buying stock with a portion of the funds provided by the brokerage house
Types of ETFs
Now more than 1,700 E T Fs available to investors such as: -Market E T Fs that mimic a stock index -Bond E T Fs containing a selection of bonds such as U.S. Treasury bonds -Sector E T Fs that focus on an industry -Foreign currency E T Fs -Numerous others
Common stock is _____ and _____ than preferred stock.
Common stock is more volatile and more risky than preferred stock.
Dividends are normally _____ distributions of the firm's earnings to the stockholders.
Dividends are normally quarterly distributions of the firm's earnings to the stockholders.
Investment returns: bonds
Coupon payments and bond price appreciation
The types of stock investments are particularly tempting for stock investors are:
IPOs
Electronic Communication Networks (ECN)
OTCs are ECNs -computer systems that match up desired purchases and sales of stocks ▪Allow for after-hours trading No person needed to perform the exchange
Return from investing in a mutual fund: Dividend distributions
Dividends received on stocks in the funds are distributed to shareholders
Portfolio managers
Employee of a financial firm that make investment decisions
Which of the following is not a common investment mistake made by individuals?
Filing for bankruptcy in order to salvage certain investments.
Index funds
Funds that attempt to mirror the movements of an existing stock index
Open-end mutual funds definition
Funds that sell directly to investors and repurchase those shares when the investor wishes to sell them
High-yield (junk) bond funds
High risk-High Yield debt security
Return from investing in a mutual fund: Capital gains from redeeming shares
If price received at redemption exceed price paid
Day traders
Investor who buys and then sells stock on the same day
Investors can use the _____ to analyze the firm's sources of funds and how it has invested those funds. The balance sheet shows the firm's _____ and _____.
Investors can use the balance sheet to analyze the firm's sources of funds and how it has invested those funds. The balance sheet shows the firm's assets and its liabilities and shareholder's equity.
common stock
Issued by a corp to raise funds, and represents partial ownership
Preferred stock
Issued by a corp to raise funds, but with first priority to receive dividends
Odd Lot
Less than 100 shares of stock
Net asset value (NAV)
Market value of securities that a mutual fund has purchased minus any liabilities owned
Mutual funds _____ and invest the proceeds in a portfolio of investments such as bonds or stocks.
Mutual funds sell shares to individuals and invest the proceeds in a portfolio of investments such as bonds or stocks.
What other exchange trades stocks in a similar manner to the NYSE?
NYSE MKT LLC
Placing an order on stocks
Name of the stock ▪Ticker symbol: the abbreviated term that is used to identify a stock for trading purposes Buy or Sell—specify what you want to do Number of shares ▪Round lot: shares bought or sold in multiples of 100 ▪Odd lot: less than 100 shares of stock
Future Stock Price formula
Present stock price * (1 + i (decimal)^n i= interest rate n= number of years until end of period
Return from investing in a mutual fund: Capital gains distributions
Proceeds received from the sale of securities are distributed to shareholders
Stock quotations
Provide information about the price of each stock over the previous day or a recent period Other information such as 52-week high and low prices, dividend yield, P/E ratio, and volume are also typically provided
Diversification
Spreading the risk across different types of investments
Stock prices tend to _____ when inflation is expected to _____.
Stock prices tend to decrease when inflation is expected to increase.
Growth stocks
Stocks of firms with substantial growth opportunities
income stocks
Stocks that provide investors with periodic income in the form of dividends
The primary and secondary stock markets differ in which of the following aspects?
The primary stock market offers newly issued securities and the secondary stock market offers existing securities.
Market risk
The susceptibility of a fund's performance to general market conditions
Standard deviation
The degree of volatility in the stocks returns over time
Initial public offerings
The first offering of a firms stock to the public
The _____ shows the firm's _____ over a particular period of time
The income statement shows the firm's revenues, expenses, and earnings over a particular period of time
The most important statistic mentioned in the prospectus is the _____ ratio.
The most important statistic mentioned in the prospectus is the expense ratio.
Gross domestic product (GDP)
Total market value of all products and services produced in a country
technical analysis
Valuation of stock based on historical price patterns
Mutual Fund Prospectus
a document that provides financial information about a mutual fund, including expenses and past performance
Stock prices are more sensitive in industries where:
borrowing is used by consumers.
A prospectus does not:
breakdown fees and expenses associated with a fund
A prospectus:
can be ordered over the phone, by e-mail, and via the Internet.
If a mutual fund's shares decline over time, individual investors would have a:
capital loss
The two main advantages of using online brokerage services are the:
convenience and low cost per transaction
Stocks are financial instruments representing partial ownership in a:
corporation
Your first investing priority should be to:
ensure adequate liquidity The disadvantage of investments that satisfy that priority is: a relatively low return
Stocks are a common investment for those who believe that they will get a:
higher return from stocks than from other investments.
Investment objective
in a prospectus, a brief statement about the general goal of the mutual fund
An investor can find price quotations for closed-end and open-end funds:
in financial papers and at financial websites.
Stocks that deliver large dividends are:
income stocks.
Dividends are usually paid by older, more established firms that have:
less potential for substantial growth.
An odd lot is an order for:
less than 100 shares of stock
Hedge funds
limited partnerships that manage portfolios of funds for wealthy individuals and financial institutions hedge funds are not regulated but the brokerages they use are
Online orders have:
low commission
A mutual fund's net asset value (NAV) is the:
market value of all the securities it has purchased minus any liabilities owed. -commonly reported as NAV/# shares ourstanding
The market value of a stock is determined by:
multiplying the number of shares outstanding by the market price of the stock.
Investors should pay attention to expense ratios because:
mutual funds are only worthwhile if they offer a high enough return to offset the extra expenses.
Index bond funds
mutual funds that are intended to mimic performance of a specified bond index
Corporate bond funds:
mutual funds that focus on bonds issued by high-quality firms that tend to have a low degree of default risk
International Sock Funds
mutual funds that focus on firms that are based outside the U.S.
Small capitalization (small-cap) funds:
mutual funds that focus on firms that are relatively small
Equity income funds:
mutual funds that focus on firms that pay a high level of dividends
Treasury bond funds
mutual funds that focus on investment in Treasury bonds
Mid-size capitalization (mid-cap) funds:
mutual funds that focus on medium-size firms
High-yield (junk) bond funds:
mutual funds that focus on relatively risky bonds issued by firms that are subject to default risk
Capital appreciation funds:
mutual funds that focus on stocks that are expected to grow at a very high rate
Growth funds:
mutual funds that focus on stocks that have potential for above-average growth
Ginnie Mae funds:
mutual funds that invest in bonds issued by the Government National Mortgage Association
Global bond funds
mutual funds that invest in foreign bonds as well as U.S. bonds
Municipal bond funds:
mutual funds that invest in municipal bonds
Socially responsible stock funds:
mutual funds that screen out firms viewed by some as offensive
The most effective way to diversify your investments is to diversify among various types of investments that are:
not equally sensitive to economic conditions.
Coupon or dividend payments generated by a mutual fund's portfolio are:
passed on to the individual investor.
Corporations sell stock in order to:
raise funds for expansion of their business operations.
Two terms that measure risk are:
range of return and standard deviation of the returns.
On a given day for open-end mutual funds
redemptions may exceed the value of the new shares purchased and fund managers may need to find the necessary funds to cover the redemptions through sale of stocks in the portfolio.
Top managers of a firm may be tempted to use misleading estimates of revenues and expenses because:
reported earnings influence the stock value and the firm value, and this is a component of managers' evaluation and compensation.
Measuring investment return
return= (selling price - purchase price)/purchase price
Measuring investment return with dividends
return= [(selling price - purchase price)+ dividend] /purchase price
Maturity classifications
some funds are also segmented by their maturities
The price of a stock changes each day in response to changes in the:
supply and demand for the stock in the secondary market.
The two main aspects that define risk concerning investments are uncertainty:
surrounding both the coupon payment and how the price of the investment will change.
Before making an IPO type of investment, individual investors must consider:
that the long-term return on IPOs is weak compared to aggregate stock indexes.
Stock Quotations- Price quotations readily available from:
the Internet, stock brokers or financial newspapers
Expense ratio
the annual expenses per share divided by the net asset value of a mutual fund -Average expense ratio is 1.25 percent -Reported components of expense ratios ▪Portfolio management fees ▪12b-1 fees ▪Mutual funds incur expenses for administrative, legal, and clerical expenses as well as portfolio management fees and 12b-1 fees ▪Funds with lower expense ratios tend to outperform other funds with similar objectives
When buying a stock on margin, an investor borrows a portion of the funds to buy the stock from:
the brokerage firm.
For open-end funds, if a company offers several different funds:
the company name is listed in bold and the funds are listed below.
The difference between no-load and load mutual funds is:
the fee charged when you purchase them.
If the value of the stock bought on margin declines:
the investor may get a margin call from the brokerage firm to put additional cash in his account to back the loan.
The market price of the stock depends on:
the number of investors willing to buy a stock versus the number of investors willing to sell.
Managers may be able to boost the reported earnings of their firm by:
using a specific accounting method.
Mutual funds incur expenses such as:
administrative, legal, and clerical expenses and portfolio management fees.
Studies on mutual funds have found that:
no-load funds outperform load funds when considering the fees paid on load funds on average.
Selecting among mutual funds
•Determine investment objectives •Evaluate your risk tolerance •Decide on fund characteristics desired •Reviewing a mutual fund's prospectus -Prospectus: a document that provides financial information about a mutual fund, including expenses and past performance
Diversification among mutual funds
•Diversify among several types of funds to lower risk •Best strategy is to diversify across stock and bond mutual funds •Can also diversify among mutual funds representing different countries
Paying off Debt
•First, review personal balance sheet •Consider paying off loans before investing •Even though investing may be more attractive, paying liabilities first usually makes more sense, particularly when loan rates are higher than anticipated investment returns •Ensure adequate liquidity
Analyzing stocks
•Price is determined by the interaction of supply and demand for a particular stock •Technical analysis: the valuation of stocks based on historical price patterns •Fundamental analysis: the valuation of stocks based on an examination of fundamental characteristics such as revenue or earnings, or the sensitivity of the firm's performance to economic conditions
Other types of investments
•Real estate -Buying a home or investing in rental property or land •Precious Metals -Gold, platinum, silver, palladium -Bullion, mining stocks, E T Fs
Types of mutual funds
•Stock mutual funds: funds that sell shares to individuals and invest the proceeds in stocks •Bond mutual funds: funds that sell shares to individuals and invest the proceeds in bonds •All are managed by professional portfolio managers who decide what securities to purchase
Exchange-traded funds (ETFs):
•funds that are designed to track other assets such a particular stock index (like index funds), a particular bond index, a commodity, or a basket of assets. -ETFs trade like stocks on a specific exchange -Can be bought and sold throughout the day -Price fluctuates accordingly -Currently more than $4 trillion invested in ETFs
Net asset value (NAV):
•the market value of the securities that a mutual fund has purchased minus any liabilities owed -Usually reported on a per share basis
Open-end fund quotations
▪Column 1—Investment company in bold type with funds listed beneath ▪Column 2 — NAV ▪Column 3—Net change in NAV ▪Column 4—Return year to date ▪Column 5—3-year return
Differing tax rates on returns
▪Interest payments and coupon payments taxed as ordinary income ▪Capital gains from investments held one year or less are taxed as ordinary income ▪Capital gains from investments held more than one year are subject to a long-term capital gains tax
Market order or limit order
▪Market order: an order to buy or sell a stock at its prevailing market price ▪Limit order: an order to buy or sell a stock only if the price is within the limits that you specify
Accounting fraud related to stock evaluations
▪Motivation for fraud -Manager compensation ▪In the early 2000s many firms used fraudulent financial statements ▪Enron and WorldCom are the most prominent examples
Madoff fund scandal
▪Reported favorable returns when the actual returns were much worse ▪Investors should have been suspicious
Stocks and Interest rates
▪Stocks perform better when interest rates are low ▪Some stocks are more sensitive to interest rates than others ▪The Federal Reserve uses monetary policy to influence interest rates ▪Monetary policy - policy established by the Federal Reserve to adjust the supply of funds in the financial system in order to influence interest rates
