Investments: Analysis and Behavior Chapter 3- Buying and Selling Equities

Learning Objectives Know the costs of trading securities. Be able to place a buy or sell order. Be able to compute margin debt and returns for long and short positions. Implement a dollar cost average strategy. Compute the impact of taxes on investment returns. Examine the Initial Public Offer market.

Buying and Selling Stocks Stock Price Quotes Bid is the highest price a market maker is willing to pay (and is lower than the ask). Ask is the lowest price a market maker is willing to accept to sell. Bid-Ask Spread is the gap between the ask and the bid quotes. Profit goes to the market maker Market depth How many people are buying and selling? How much can I buy or sell without moving the price? Bid size: the number of shares offered at the bid price Ask size: the number of shares offered at the ask price

Quote from dealer market VWAP = Volume Weighted Average Price = The ratio of the value traded to total volume traded over a particular time horizon (usually one day). It is a measure of the average price a stock traded at over the trading horizon.

Quote from specialist market VWAP = Volume Weighted Average Price = The ratio of the value traded to total volume traded over a particular time horizon (usually one day). It is a measure of the average price a stock traded at over the trading horizon.

Buy now, or wait for a better price? Market order (executed immediately) Buy (or sell) now at market price “Buy 50 shares of Home Depot at market” “Sell 100 shares of Apple Computer at market” Limit order (may take awhile to execute, or never) Buy when the price gets a little better How long to wait? “Sell 100 shares of IBM at $82.70 or better, today” “Buy 200 shares of Dell at $30.72 or better, fill or kill” When would these trades execute? See pages 62-64 for specific orders

Place an order to trade when certain price levels are reached (before the emotions set in!) Stop order Placing an order to sell a stock after the price has risen to a specified price. Stop-loss order Placing an order to sell when a stock falls to a specific price.

Pitfalls to Trading Active trading (day trading) Induces the same emotions as casinos try to elicit. Investment decisions are more likely to be influenced by emotions and psychological biases. The allure of active trading is strong. People who believe they have superior information or skill feel like they should benefit by trading Trading costs are important! (commissions and bid-ask spread (the amount by which the ask price exceeds the bid))

Illusions Illusion of Knowledge Illusion of Control The illusion that more information creates more knowledge and better predictions Does telling you what the last five rolls of a dice help you predict what the next roll will be? The internet is full of information How much is true? Can you turn this info into wisdom? Illusion of Control People often believe that they have influence over the outcome of uncontrollable events. People seem to believe that they have greater odds of winning the lottery with their own numbers than randomly picked numbers. These illusions may cause investors to trade too much and eventually experience lower returns!

Impact on Return Before going online: After going online: A study of 1,607 investors which moved from discount broker to online broker. Before going online: average turnover was 70% beat the market by 2.4% per year After going online: turnover jumped to 120% under performed the market by 3.5% per year Brad Barber and Terrance Odean, 2002, “Online Investors: Do the Slow Die First?” Review of Financial Studies, 15, 455-487.

Buying Stocks Using Debt Cash account Most investors use a cash account. They fund the account with cash and then use the cash to buy stocks. Margin account You can borrow money from the brokerage firm to buy more stock. You must start with no less than 50% of the position as your equity (called initial margin). If the stock price falls, it is your equity that is declining If your margin falls below the minimum maintenance margin level you will be forced to sell or add more cash.

Computing your equity in a margin position Consider that you borrowed $10,000 to buy $20,000 of stock. If the value of the stock increases to $25,000, what is your margin? If the value of the stock declines to $15,000, what is your margin?

Profiting From Falling Stock Prices The simple rule of “buy low, sell high” works well when prices are increasing. When prices are falling, can you “sell high, buy low?” Selling short (or short selling) By executing a short sale, the investor sells stock that they do not own (by borrowing it from the brokerage). Later, after the price falls (hopefully!) the stock is repurchased (called covering the short) and return to the broker. *** You borrow  You sell  You buy back

Short Example Short 100 shares at $60 Total proceeds: $60 × 100 = $6,000 What is the equity margin and return if the price rises to $66? Loss = ($60 - $66) × 100 = -$600

Short Example What is the return if the price falls to $50? P = $75 Profit = ($60 - $50) × 100 = $1,000 P = $75 P = $46 P = $20 P = $100

Dollar-Cost Averaging A Rising Market A Falling Market A Volatile Market Monthly Share Shares Investment Price Purchased $400 $4.00 100 $50.00 8 $40.00 10 400 8.00 50 25.00 16 16.00 25 10.00 40 20.00 20 12.50 32 4.00 5.00 80 40.00 50.00 Totals $4,800 $216.00 405 $216. 450 $216.0 480 Average price $18.00 $11.85 $18.0 $10.67 $10.00

Impact of Taxes Capital Gains Dividends Interest Income Only realized gains are taxed Short-term (less than one year) taxed at marginal income tax rate Long-term (over one year) Taxed at 20% Dividends Taxed at 15% Interest Income Taxed at marginal income tax rate Marginal Tax Rate = change in tax liability / change in taxable income = the tax rate that applies to the last dollar of the tax base (taxable income or spending)

After-tax value of a $4,000 investment per year The tax man cometh After-tax value of a $4,000 investment per year Number earning 12% with annual income taxes paid at a rate of of Years 0% 30% 40% 50% 1 $4,000 $2,800 $2,400 $2,000 5 25,411 16,558 13,857 11,274 10 70,195 41,341 33,474 26,362 15 149,119 78,435 61,247 46,552 20 288,210 133,955 100,565 73,571 25 533,335 217,053 156,227 109,729 30 965,331 341,430 235,029 158,116

Investing and Taxes Tax rules change over time! Tax deferred investing IRA, 401(k) plans Defers the taxes until the money is withdrawn in retirement. Roth IRA Pay the tax now, but no taxes in retirement. With constant tax rates IRAs and Roth IRAs are equivalent tax shelters.

IRAs 2010 Combined Traditional and Roth IRA Contribution Limits If you are under 50 years of age at the end of 2010: The maximum contribution that you can make to a traditional or Roth IRA is the smaller of $5,000 or the amount of your taxable compensation for 2010. This limit can be split between a traditional and a Roth IRA but the combined limit is $5,000. The maximum contribution to a Roth IRA and the maximum deductible contribution to a traditional IRA may be reduced depending upon your modified adjusted gross income (modified AGI). If you are 50 years of age or older before 2011: The maximum contribution that can be made to a traditional or Roth IRA is the smaller of $6,000 or the amount of your taxable compensation for 2010. This limit can be split between a traditional and a Roth IRA but the combined limit is $6,000. The maximum contribution to a Roth IRA and the maximum deductible contribution to a traditional IRA may be reduced depending upon your modified AGI. http://www.irs.gov/retirement/participant/article/0,,id=188232,00.html

Issuing New Securities New securities are issued with the help of investment banks (or underwriter) New issues are sold on the primary market first, and subsequently sell on the secondary market. The secondary markets are the security exchanges. The selling of shares for the first time in a new company is called a initial public offering (IPO)

Issue Amount (millions) Underwriting fees of top investment banks in the first quarter of 2008 Issue Amount (millions) Market Share Number of Deals Citigroup $506.7 8.9% 397 JP Morgan 483.9 8.5 402 Banc of America Sec. 426.8 7.5 216 Goldman Sachs & Co 388.4 6.9 197 Merrill Lynch 321.7 5.7 354 Deutsche Bank AG 282.6 5 302 UBS 282.5 5.0 360 Morgan Stanley 264.2 4.7 297 Credit Suisse 233.1 4.1 285 Lehman Brothers 227.3 4 192 Top 10 Totals $3,417.1 60.3% 3,002 Industry Totals $5,665.9 100.0% 3,780

Who gets IPO shares? Hot Issue Market Cold market Who gets shares? During some robust markets, over 50 news firms go public every month. Many investors want these shares. Initial returns can be high. Cold market During other periods, less than 10 IPOs are issued in a month. Who gets shares? Those who want shares ask their broker. When more shares are sought than are being issued priority tends to go to the broker’s best clients. If you are a small-money investor and receive shares of an IPO, look out, it may be a lemon!