1 Investments: Prices and Great Investors Business Administration 365 Professor Scott Hoover

2 Market Structure  Participants investors brokers traders dealers  specialist  market maker

3  Orders security (e.g., ticker) size expiration  time until the order expires if it has not been filled types  market  trade at the current market price  limit  buy (sell) only if the price is below (above) a certain price  example: a limit buy order at $10 can be filled only if the price is at or below $10

4  stop  opposite of a limit order… buy (sell) only if the price is above (below) a certain price  example: a stop sell order at $10 can be filled only if the price is at or below $10  stop limit  combination of a stop and limit order (investor specifies both a stop and a limit price)  example: an investor may submit a buy order with a stop price of $10 and a limit price of $12. The order becomes a limit order at $12 when another trade occurs at $10 or higher.  Under what circumstances would we use each order type?

5  short sales  the sale of an asset without ownership of the asset  investor places a short sale order with broker  broker borrows shares  shares are sold, with the proceeds accruing to the investor  At some subsequent date, the investor must purchase shares to close the position. Those shares are returned to the lender.  The investor must pay all dividends that occur during the short period.

6 margins  initial margin (IM)  percentage of investment that the investor contributes  example: 70% IM, 1000 shares at $6 per share  investor must pay $4200  broker loans $1800 to the investor  actual margin (AM)  difference between the market value (MV) of assets held and the loan amount, as a % of the MV of the assets.  example: 70% IM, 1000 shares at $6 per share, current share price $3  investor borrows $1800  shares are worth $3000  AM = ($3000-$1800)/$3000 = 40%

7  maintenance margin (MM)  minimum AM that the investor must maintain in the account.  example: 40% MM, 70% IM, 1000 shares at $6 per share  investor borrows $1800  The MM is violated if the MV of the stock drops below $3,000.  margin call  when the MM is crossed, the investor must deposit additional funds to bring the AM above the MM  Typically, the required deposit is some multiple of the amount needed to get back to the MM

8  Miscellaneous items  Margin accounts are aggregated.  Brokers charge interest (call money rate) on the loans.  Collateral does not always count at full value.  Similar margin rules apply to short sales, although the margin calculation is a bit different.  “Trading Places” video

9 Prices and Quotes  important terms bid price  the quoted price at which the specialist is willing to buy shares (often on behalf of another investor who has placed a buy order) bid depth  # of shares the specialist is willing to buy at the bid price. ask price (or offer price)  the quoted price at which the specialist is willing to sell shares (often on behalf of another investor who has placed a sell order) ask (offer) depth  # of shares the specialist is willing sell at the ask price. bid-ask spread  ask price – bid price example: (1000) – (500).  ask = $19.56; ask depth = 500; bid = $19.47; bid depth = 1000; spread = $0.09.

10 The best prices available are called the BBO or “best bid or offer”  …quoted to potential investors  …is based on the limit order or the supply/demand from the specialist.  …if quoting out of his/her own account, the specialist must quote a better price than the best price in the limit order book

11  Market Efficiency We say that markets are efficient if we cannot earn positive abnormal profits consistently over time. Efficiency vs. Accuracy  It is possible to have completely inaccurate prices yet still have efficient markets.  For markets to be inefficient, we must be able to predict abnormal price movements The evidence  If markets are efficient, a paradox arises. Therefore, markets cannot be efficient. –Sandy Grossman and Joe Stiglitz  The stock market is “slow to overreact” –Robert Haugen  Anecdotal evidence

12  How might we take advantage of mispricings? Absolute mispricings  buy undervalued assets  short overvalued assets Relative mispricings  one approach: form “market-neutral” portfolios  …designed to have little or no impact when the market moves.  example: Suppose we believe Eli Lilly is underpriced relative to Pfizer (same industry, similar size)  We could buy Eli Lilly stock and short Pfizer  implication: If the market drops noticeably, the losses on Lilly will tend to be offset by gains on Pfizer.  We could earn abnormal profits if Lilly is undervalued relative to Pfizer.

13 Dollar-Cost Averaging  When we choose to buy a stock, should we invest all at once or build a position over time?  Intuition: It is often better to buy a little bit at a time (in equal amounts) than to buy all at once.  Strategy: We invest a specific amount each period.  Why? We buy more shares when the price is low, thereby giving us a lower cost per share.  Example: Suppose we invested $10,000 each of two days  stock prices = $10, $20  Total shares purchased = = 1500  Suppose instead that we invested the $20,000 at the average price of $15  Total shares purchased = 1,333  When would this not work?

14 A Few Lessons from Great Investors  S&P 500 Index As we will see in Homework #2, the S&P500 index is a great “investor.” A few of many lessons from the S&P:  Buy strong companies  Diversify  Let winners run  Warren Buffett Invest for the long-run Buy only the stocks of companies with the potential to be great companies.

15  Peter Lynch Recurring cash flows are much more important that single cash flows. Insider transactions are a critical piece of information  We must be careful not to read too much into them.  Bill Miller The market often overreacts to bad news. A few big winners can make the entire portfolio successful.  e.g., Dell from in the 1990s.  Suppose you had invested your money in Dell and 29 other stocks.  If all the others went bankrupt, your portfolio would still have earned an annualized return of about 40%.