Chapter Twenty-One Understanding Securities Markets and Investments

Learning Objectives 1.Develop a personal investment plan. 2.Explain how the factors of safety, risk, income, growth, and liquidity affect your investment decisions. 3.Describe how securities are bought and sold. 4.Identify the advantages and disadvantages of savings accounts, bonds, stocks, mutual funds, and real estate. 5.Describe high-risk investment techniques. 6.Use financial information to evaluate investment alternatives.

Developing an Investment Plan Personal investment –The use of your personal funds to earn a financial return Investment goals –Personal investment goals must be Specific and measurable Tailored to individual needs Focused on the future Realistic in terms of economic conditions and opportunities

Developing an Investment Plan (cont’d) Questions to consider when establishing goals –What financial goals do you want to achieve? –How much money will you need, and when? –What will you use the money for? –Is it reasonable to assume that you can obtain the amount of money you will need to meet your investment goals? –Do you expect your personal situation to change in a way that will affect your investment goals? –What economic conditions could alter your investment goals? –Are you willing to make the necessary sacrifices to ensure that your investment goals are met? –What are the consequences of not obtaining your investment goals?

Developing an Investment Plan A personal investment plan –Involves a careful evaluation of different investment opportunities –Financial planner An individual who has had at least two years of training in investments, insurance, taxation, retirement planning, and estate planning and has passed a rigorous examination –Begin by accumulating an emergency fund –Invest funds according to your plan –Monitor the plan

Developing an Investment Plan (cont’d) Suggestions to help you accumulate the money needed to fund an investment plan –Learn to balance your budget –Make savings a higher priority –Take advantage of employer-sponsored retirement programs –Participate in an elective savings program –Make a special savings effort one or two months each year –Take advantage of gifts, inheritances, and windfalls Source: Jack R. Kapoor, Les R. Dlabay, and Robert J. Hughes, Personal Finance, 7th ed. (Burr Ridge, IL: Irwin-McGraw Hill, 2004), p. 421.

Important Factors in Personal Investment Match potential investments with your goals in terms of several factors –Safety and risk Minimizing the risk of loss (e.g., investing in blue-chip stocks) Maximizing potential returns by assuming some risk –Investment income Predictable interest and dividends from stable investments (e.g., certificates of deposit, corporate and government bonds, and certain stocks) –Investment growth An increase in the value of an investment, such as mutual funds and real estate that appreciate in value –Investment liquidity The ease with which an investment can be converted into cash

How Securities Are Bought and Sold Securities are usually exchanged with the help of an account executive or stockbroker The primary market –A market in which an investor purchases financial securities (via an investment bank) directly from the issuer of those securities Investment banking firm—an organization that assists corporations in raising funds, usually by helping sell new issues of stocks, bonds, or other financial securities High-risk investment—an investment (e.g., an IPO) made in the uncertain hope of earning a relatively large profit in a short time Institutional investors—pension funds, insurance companies, mutual funds, banks, and other organizations that trade large quantities of securities

How Securities Are Bought and Sold (cont’d) The secondary market –A market for existing financial securities that are traded between investors –Securities exchange—a marketplace where member brokers meet to buy and sell securities New York Stock Exchange (NYSE), American Stock Exchange, regional exchanges, foreign exchanges –Over-the-counter (OTC) market—a network of dealers who buy and sell the stocks of corporations that are not listed on a securities exchange Nasdaq—computerized electronic exchange system through which most over-the-counter stocks are traded

Criteria a Firm Must Meet Before Being Listed on the NYSE Source: New York Stock Exchange, February 9, 2003.

How Securities Are Bought and Sold (cont’d) The role of an account executive –An individual, sometimes called a stockbroker or registered representative, who buys and sells securities for clients Full-service broker—provides personal investment advice and other market and investing information Discount broker—simply executes buy and sell orders for lower commissions than a full-service broker; does not offer advice

Steps in a Typical Stock Transaction on the NYSE

How Securities Are Bought and Sold (cont’d) The mechanics of a transaction –Market order A request that a security be purchased or sold at the current market price –Limit order A request that a security be bought or sold at a price that is equal to or better than some specified price –Discretionary order An order to buy or sell a security that lets the broker decide when to execute the transaction and at what price

How Securities Are Bought and Sold (cont’d) Online security transactions –Software can help investors evaluate potential investments, manage investments, monitor value, and place buy and sell orders online –Investors must still analyze the information and make decisions –Online trading generally has lower costs –Program trading—a computer-driven program that monitors the market value of particular stocks and enters buy or sell orders when those stocks reach specified prices

How Securities Are Bought and Sold (cont’d) Commissions –Most brokerage firms have a minimum commission –Additional commission charges are based on the number of shares and the value of stock bought and sold –Full-service brokerages charge a percentage of the transaction amount (as much as 1.5 to 2.0%) –Discount brokers charge lower commissions or a fixed fee amount per transaction –Commissions for bonds, commodities, and options are lower than for stocks –Round lot—a unit of 100 shares of a particular stock –Odd lot—fewer than 100 shares of a particular stock

Regulation of Securities Trading State regulation –States require registration of stock issues and licensing of brokers and securities dealers Federal regulation –Securities Act of 1933 (Truth in Securities Act) Requires registration statement about the corporation and a prospectus describing the new security –Securities and Exchange Commission (SEC) The agency that enforces federal securities regulations –National Association of Securities Dealers (NASD) The organization responsible for the self-regulation of the over-the-counter securities market –Several other acts including Sarbanes-Oxley Act (2002)

Traditional Investment Alternatives Portfolio management –Depends on your investment goals, tolerance for risk, financial resources available for investment Asset allocation, the time factor, and your age –Asset allocation—the process of spreading your money among several different types of investments to lessen risk –The time factor—investing for the long term or the short term –Age—growth-oriented investments versus conservative investments

Traditional Investment Alternatives (cont’d) Bank accounts –Advantages—bank accounts are safe (low risk) and have definite rates of return –Disadvantage—low risk means low investment returns Corporate bonds –Primarily a long-term, income-producing investment with a value that fluctuates with market interest rates and the financial condition of the issuer Convertible bonds –Interest-bearing corporate bonds that can also be exchanged for a specific number of shares of common stock –Bond market value is equal to the underlying value of the stock

Traditional Investment Alternatives (cont’d) Government bonds –Considered risk free; pay low interest –Treasury bills—sold in minimum units of $1,000; short maturities –Treasury notes—issued in $1,000 units with maturity of 1 to 10 years –Treasury bonds—issued in minimum units of $1,000 with maturities from 10 to 30 years –Savings bonds—(EE bonds) purchased for ½ their maturity value –Municipal bonds—issued by a state or local government; may be exempt from federal taxes

Traditional Investment Alternatives (cont’d) Common stock –Dividend income Stock dividend—a dividend in the form of additional stock Dividend payments—cash payments as the result of a distribution of the company’s profits –Increase in dollar value Capital gain— the difference between a security’s purchase price and its selling price Market value—the price of one share of a stock at a particular time –Stock splits A division of each outstanding share of a corporation’s stock into a greater number of shares Reduces the stock price to a price range that management feels is attractive for the stock

Traditional Investment Alternatives (cont’d) Preferred stock –Stock in a corporation that has a claim on the dividends that supercedes common stock –Cumulative preferred stock Stockholders have priority claim to full payment of all omitted dividends and corporate assets –Convertible preferred stock Stock that pays dividends and can also be exchanged for a fixed number of shares of common stock

Traditional Investment Alternatives (cont’d) Mutual funds –A professionally managed investment vehicle that combines and invests the funds of many individual investors –Closed-end funds Funds with a fixed number of shares –Open-end funds Funds with an unlimited number of shares –Net asset value (NAV) Net asset value Value of the fund’s portfolio – Liabilities Number of shares outstanding = Current market value of a mutual fund’s portfolio minus the mutual fund’s liabilities and divided by the number of outstanding shares

Traditional Investment Alternatives (cont’d) Mutual funds (cont’d) –Load funds Investors pay sales and purchase fees every time they purchase shares –No-load funds No sales or purchase fees are charged –Yearly management fee –Managed funds Professional fund manager chooses securities in the fund –Index funds Managers buy stocks or bonds contained in an index (such as Standard & Poor’s 500) –Family of funds A group of mutual funds managed by one investment company

Traditional Investment Alternatives (cont’d) Major categories of mutual funds –Aggressive growth funds –Asset-allocation funds –Balanced funds –Bond funds –Global funds –Growth funds –Growth-income funds –Income funds –Index funds –International funds –Money-market funds –Sector funds –Small-cap funds

Traditional Investment Alternatives (cont’d) Real estate –Advantage One of the best hedges against inflation –Disadvantages Risk of the property losing of value due to poor location Buyers may be difficult to locate Real estate market may be in decline at time of sale Taxes, mortgage interest, and Installment payments can be a heavy burden

High-Risk Investment Techniques Selling short –The process of selling stock that an investor does not actually own but has borrowed from a brokerage firm and will repay at a later date –Assuming that the stock is overvalued and will soon decrease in price, the investor intends to repay the brokerage later with less costly stock, resulting in a profit for the investor Buying stock on margin –Buying stock by borrowing part of the purchase price, usually from a stock brokerage firm Margin requirement—the portion of the price of a stock that cannot be borrowed; set by the Federal Reserve Board

High-Risk Investment Techniques (cont’d) Other high-risk investments –Stock options –Commodities –Precious metals –Gemstones –Coins –Antiques and collectibles

Sources of Financial Information The Internet – – – – – – – Newspaper coverage of securities transactions –Common and preferred stocks –Bonds –Mutual funds

Reading Stock Quotations Source: Wall Street Journal, February 12, 2003, p. C3.

Reading Bond Quotations Source: Wall Street Journal, February 12, 2003, p. C15.

Reading Mutual Fund Quotations Source: Wall Street Journal, February 12, 2003, p. D8.

Sources of Financial Information Other sources of financial information –Investors’ services Moody’s, Standard & Poor’s, Mergent, Value Line, Morningstar, Lipper Analytical Services, Wiesenberger Investment Companies –Brokerage firm analysts’ reports UBS PaineWebber, Smith Barney, Merrill Lynch –Business periodicals Business Week, Fortune, Forbes Advertising Age, Business Insurance U.S. News & World Report, Time, Newsweek Money, Kiplinger’s Personal Finance Magazine, Consumer Reports –Corporate reports

Sources of Financial Information (cont’d) Security averages –An average of the current market prices of selected securities –Dow Jones Industrial Average 30 leading industrial corporations –Standard & Poor’s 500 Stock Index –New York Stock Exchange Composite Index –American Stock Exchange Index –Nasdaq Composite Index