1. The Investment Process2
The Investment Process

2. Learning Objectives
Don’t sell yourself short. Instead, learn about these key investment subjects:
1. The various types of securities brokers and brokerage accounts.
2. How to calculate initial and maintenance margin for investing on margin.
3. The workings of short sales.
4. The importance of investor objectives, constraints, and strategies.

3. Forming an investment portfolio

4. Investment Objectives
Fundamental Question: Why invest at all?
We invest today to have more tomorrow.
Investment is simply deferred consumption.
We choose to wait because we want more to spend later.
In formulating investment objectives, the individual must balance return objectives with risk tolerance.
Investors must think about risk and return.
Investors must think about how much risk they can handle.

5. Investment Strategies and Policies
Investment management. Should you manage your investments yourself?
Market timing. Should you try to buy and sell in anticipation of the future direction of the market?
Asset allocation. How should you distribute your investment funds across the different classes of assets?
Security selection. Within each class, which specific securities should you buy?
Policy Statement A policy statement is the statement that contains the investor's goals and constraints as it relates to his investments. This could be considered to be the most important of all the steps in the portfolio management process. The statement requires the investor to consider his true financial needs, both in the short run and the long run. It helps to guide the investment portfolio manager in meeting the investor's needs. When there is market uncertainty or the investor's needs change, the policy statement will help to guide the investor in making the necessary adjustments the portfolio in a disciplined manner. Expressing Investment Objectives in Terms of Risk and Return Return objectives are important to determine. They help to focus an investor on meeting his financial goals and objectives. However, risk must be considered as well. An investor may require a high rate of return. A high rate of return is typically accompanied by a higher risk. Despite the need for a high return, an investor may be uncomfortable with the risk that is attached to that higher return portfolio. As such, it is important to consider not only return, but the risk of the investor in a policy statement.

7. Asset Allocation or Security Selection?
Is asset allocation or security selection more important to the success of a portfolio?
Most people are inclined to think security selection is the more important element for successful investing.
Research shows, however, that asset allocation is the more important determinant of portfolio returns. Many experts suggest:
About 90 percent of portfolio performance stems from asset allocation.
So, 10 percent of portfolio performance comes from security selection.
How is this result possible? Well, consider the Crash of 2008.
Bonds outperformed stocks in 2008
Even those elusive “skilled stock pickers” might underperform bonds
Stocks tend to move together
Even a “skilled stock picker” would have trouble beating bonds if most stock prices are performing poorly relative to bond prices

8. Investor Constraints
Resources. What is the minimum sum needed? What are the associated costs?
Horizon. When do you need the money?
Liquidity. How high is the possibility that you need to sell the asset quickly?
Taxes. Which tax bracket are you in?
Special circumstances. Does your company provide any incentive? What are your regulatory and legal restrictions?

9. Forming a Real Investment Portfolio, I.
Take the Risk Tolerance Quiz in the textbook.
What score did you get?

10. Forming a Real Investment Portfolio, II.
What does your score mean?

11. Taxes in Investing Decisions

12. Taxes in Investing Decisions
“It’s not what you make, it’s what you keep that is important.”
Tax Planning Involves:
The desired return after-taxes
Type of income received from investments
Timing of profit-taking and loss recognition

13. Taxes in Investing Decisions (cont'd)
Types of Income for Individuals
Ordinary income
Taxed at progressive tax rates (rates go up as income goes up)
Active, portfolio and passive income included
Active Income: income from working (wages, salaries, pensions)
Portfolio Income: income from investments (interest, dividends, capital gains)
Passive Income: income from special investments (rents from real estate, royalties, limited partnerships)
Capital Gains and Losses
Capital Asset: property owned and used by taxpayer, including securities and personal residence
Capital Gain: amount by which the proceeds from the sale of a capital asset are more than its original purchase price
Capital Loss: amount by which the proceeds from the sale of a capital asset are less than its original purchase price

14. Tax Rates and Income Brackets for Individual and Joint Returns (2006 and 2012)

15. Taxes in Investing Decisions (cont'd)
Taxation of Capital Gains
Capital assets held less than one year: ordinary income tax rates
Capital assets held more than one year: 0% or 15%, depending on income level
Taxation of Capital Losses
Capital losses can be used to offset capital gains
Up to $3,000 per year of capital losses can be used to offset ordinary income (such as wages)

16. Tax-Advantaged Retirement Vehicles
Allows taxes to be deferred until withdrawn in future
Employer-sponsored plans
Profit-sharing plans, thrift and savings plans, and 401(k) plans
Self-employed individual plans
Keogh plans and SEP-IRAs
Individual plans
Individual retirement arrangements (IRAs) and Roth IRAs

17. Retirement Accounts: Company Sponsored Plans, I.
You will probably have access to a company-sponsored retirement plan such as a 401(k).
In a typical plan, you (the employee) decides how much money to contribute to the plan through payroll deductions.
Generally, your employer also makes contributions to the plan.
For example, your company could make dollar-for-dollar matching contributions up to a certain percentage of your salary.
Even after your contributions hit the maximum amount your employer will match, you can still contribute additional funds.
The amount of your total contribution is limited by the Internal Revenue Service (IRS).

18. Retirement Accounts: Company Sponsored Plans, II.
The general investing approach applies to your retirement plan.
You decide your percentage allocations to asset classes (like stocks, bonds, and T-bills) and then choose particular securities (i.e., mutual funds) in each asset class.
You will also make the decision whether to invest in U.S. securities, securities in other regions of the world, securities in specific countries, large company securities, small company securities, or a combination of these categories.
The primary benefit of company-sponsored plans is that money you deposit into the account lowers your taxable income.
So, your tax bill is lower, and your net “out of pocket” cost is lower.
For example, if you are in the 25 percent tax bracket and decide to deposit $12,000 next year, your net out of pocket cost is only $9,000.
Why? You will pay $3,000 (.25*$12,000) less in taxes than you would if you had not made this deposit.
Of course, nothing is free. You must pay taxes on the withdrawals you make during retirement.

19. Individual Retirement Accounts, IRAs
Generally, IRAs are for people who do not have access to a company-sponsored plan.
The essential difference between IRAs lies in taxes (“Pay me now, or pay me later.”)
Roth Individual Retirement Account (Roth IRA)
Today, you invest after-tax money.
Therefore, you pay no taxes when you make withdrawals.
So, capital gains and dividends accumulate tax-free.
“Tax-Deferred” or Traditional IRAs
You do not pay taxes on money you place into this account.
When money is removed from this account, you pay taxes.
Roth IRAs benefit younger investors in a low tax bracket.

20. Buying and selling securities

21. Buying and Selling Securities
This chapter covers the basics of the investing process.
We begin by describing how you go about buying and selling securities, such as stocks and bonds.
Then, we outline some important considerations and constraints to keep in mind as you get more involved in the investing process.

22. Getting Started (a) Open a brokerage or trading account
(c) Buy 100 Shares
of Disney
at $33 per share
(e) $6,650 Cash
in Account
$3,300 Stock
In Account
(d) Pay Commission,
Say $50
(b) Deposit $10,000
into account
(a) Open a brokerage
or trading account

23. Choosing a Broker, I. Brokers are now divided into three groups:
Full-service brokers
Discount brokers
Deep-discount brokers
These three groups can be distinguished by the level of service provided, as well as the level of commissions charged.

24. Major Full-Service, Premium Discount, and Basic Discount Brokers

25. Choosing a Broker, II.
As the brokerage industry becomes more competitive, the differences among broker types continues to blur.
Another important change is the rapid growth of online brokers, also known as e-brokers or cyberbrokers.
Online investing has really changed the brokerage industry.
slashing brokerage commissions
providing investment information
Customers place buy and sell orders over the Internet

26. Securities Investor Protection Corporation
Securities Investor Protection Corporation (SIPC): Insurance fund covering investors’ brokerage accounts when member firms go bankrupt or experience financial difficulties.
Most brokerage firms belong to the SIPC, which insures each account for up to $500,000 in cash and securities, with a $100,000 cash maximum.
Important: The SIPC does not guarantee the value of any security (unlike FDIC coverage).
Rather, SIPC protects whatever amount of cash and securities that were in your account, in the event of fraud or other failure.

27. Broker-Customer Relations
There are several important things to remember when you deal with a broker:
Any advice you receive is not guaranteed.
Your broker works as your agent and has a legal duty to act in your best interest.
However, brokerage firms make profits from brokerage commissions.
Your account agreement will probably specify that any disputes will be settled by arbitration and that the arbitration is final and binding.

28. Cash vs. margin trading

29. Brokerage Accounts
A Cash account is a brokerage account in which securities are paid for in full.
A Margin account is a brokerage account in which, subject to limits, securities can be bought and sold short on credit.
(more on selling short later)

30. 𝑀𝑎𝑟𝑔𝑖𝑛= 𝑌𝑜𝑢𝑟 𝑀𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
Margin Accounts
In a margin purchase, the portion of the value of an investment that is not borrowed is called the margin.
𝑀𝑎𝑟𝑔𝑖𝑛= 𝑌𝑜𝑢𝑟 𝑀𝑜𝑛𝑒𝑦 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
Where
“Your Money”
= Value of Securities minus Margin Loan
Of course, the portion that is borrowed incurs an interest charge.
This interest is based on the broker’s call money rate.
The call money rate is the rate brokers pay to borrow money to lend to customers in their margin accounts.

31. Practices Example 1: Margin requirement = 80%.
This means that your money represents at least 80% of the total dollars you spend to buy stocks.
Suppose KO is traded at $40 per share AND you have only $40,000.
Without margin, you can buy only 1,000 shares (=$40,000/$40 per share).
With margin, you can spend up $50,000 ($40,000/80%) or 1,250 shares (=$50,000/$40 per share). Margin loan is $10,000.
If KO rises to $50 per share,
new margin = (62, ,000)/62,500=84%
If KO falls to $30 per share,
new margin = (37, ,000)/37,500=73.33%
Example 2: Margin requirement = 50%.
This means that your money represents at least 50% of the total dollars you spend to buy stocks.
With margin, you can spend up $80,000 ($40,000/50%) or 2,000 shares. Margin loan is $40,000.
new margin = (100, ,000)/100,000=60%
new margin = (60, ,000)/60,000=33.33%

32. Example: Margin Accounts, The Balance Sheet
You buy 1,000 Pfizer shares at $24 per share.
You put up $18,000 and borrow the rest.
Amount borrowed = $24,000 – $18,000 = $6,000
Margin = $18,000 / $24,000 = 75%
Assets
Liabilities and Account Equity
1,000 Shares, PFE
$ 24,000
Margin Loan
$ 6,000
Account Equity
$ 18,000
Total

33. Simulation Analysis
Example: Buying 1,000 shares of stock at $24 with a margin loan of $6,000
Stock Price
Value of Securities
Margin Loan
Equity
(“Your Money”)
Margin
$24
$24,000
$6,000
$18,000
(=24,000-6,000)
75% (=18,000/24,000)
$30
30,000
6,000
24,000
80%
$20
20,000
14,000
70%
$10
10,000
4,000
40%
If the brokerage firm requires your account to maintain 50% margin and currently the stock price is $10 per share, you need to deposit additional $1,000 into an account.
Detail: 50% = X / 10,000, X=5,000. This means that you must maintain at least $5,000 equity in your account, but currently your equity is only $4,000.

34. Margin Accounts
In a margin purchase, the minimum margin that must be supplied is called the initial margin.
Initial margin is set by the Fed, usually 50%.
The maintenance margin is the margin amount that must be present at all times in a margin account.
Set by the brokerage or the exchange
When the margin drops below the maintenance margin, the broker can demand more funds. This is known as a margin call.
When the margin call is provoked, an investor must bring the margin back to the initial margin.

35. Example: The Workings of a Margin Account, I
Your margin account requires:
an initial margin of 50%, and
a maintenance margin of 30%
A Share in Miller Moore Equine Enterprises (WHOA) is selling for $50.
You have $20,000, and you want to buy as much WHOA as you can.
You may buy up to $20,000 / 0.5 = $40,000 worth of WHOA.
Assets
Liabilities and Account Equity
800 Shares of $50/share
$ 40,000
Margin Loan
$ 20,000
Account Equity
Total

36. Example: The Workings of a Margin Account, II
After your purchase, shares of WHOA fall to $35. (Woe!)
New margin = $8,000 / $28,000 = 28.6% < 30%
Therefore, you are subject to a margin call.
You must deposit $6,000 ( = 50% of $28,000 - $8,000)
Assets
Liabilities and Account Equity
800 Shares of $35/share
$ 28,000
Margin Loan
$ 20,000
Account Equity
$ 8,000
Total

37. Example: How Low Can it Go?
At what price will you receive a margin call?
The more compact way to express this formula is P*=initial stock price (1-IM) / (1-MM)

38. Example: The Effects of Margin, I.
You have $30,000 in a margin account, 60% initial margin required.
You can buy $50,000 of stock with this account (why?).
Your borrowing rate from your broker is 6.00%.
Suppose you buy 1,000 shares of Coca-Cola (KO), for $50/share.
Assume no dividends, and that your borrowing rate is still 6.00%, what is your return if:
In one year, KO is selling for $60 per share?
In one year, KO stock is selling for $60 per share, but you did not borrow money from your broker? +20%

39. Example: The Effects of Margin, II.
KO is selling for $60 per share.
Your investment is worth $60,000.
You owe 6% on the $20,000 you borrowed: $1,200.
If you pay off the loan with interest, your account balance is: $60,000 – $21,200 = $38,800.
You started with $30,000.
Therefore, your return is $8,800 / $30,000 = 29.33%.
Suppose Coca-Cola stock was selling for $40 per share instead of $60 per share? What is your return?

40. Example: The Effects of Margin, III.
Coca-Cola stock is selling for $60 per share, but you did not borrow from your broker.
You started with $30,000, which means you were able to buy $30,000 / $50 = 600 shares.
Your investment is now worth $36,000.
Therefore, your return is $6,000 / $30,000 = 20.00%.
Suppose Coca-Cola is selling for $40 per share instead of $60 per share. What is your return in this case? -20%

41. Example: Annualizing Returns on a Margin Purchase, I.
You buy 1,000 shares of Costco (COST) at $60 per share.
Your initial margin is 50%.
You borrow at the 9 percent call money rate plus 2 percent.
You sell Costco (COST) 3 months later for $63.
There were no dividends paid (and suppose the prices above are net of commissions).
What is your holding period percentage return and your EAR?

42. Annualizing Returns on a Margin Purchase, II.
Answer: First, you have to repay the 3-month loan, so: t = (3/12 = .25)
Amount Repaid = Amount Borrowed × (1 + interest rate per year)t
Amount Repaid = $30,000 × ( ).25
= $30,000 ×
= $30,792.90
Your Sale Proceeds = Cash from Sale – Amount Repaid = $63,000 – 30,792.90
= $32,207.10
Your Profit = Your Sale Proceeds – Your Investment
= $32, $30,000
= $2,207.10

43. Annualizing Returns on a Margin Purchase, III.
Note that there are 12/3 = 4 three-month holding periods in a year. Therefore, m = 4.

44. Hypothecation and Street Name Registration
Hypothecation is the act of pledging securities as a collateral against a loan.
This pledge is needed so that the securities can be sold by the broker if the customer is unwilling or unable to meet a margin call.
Street name registration is an arrangement under which a broker is the registered owner of a security. (You, as the account holder are the “beneficial owner.”)

45. Other Account Issues, I.
Trading accounts can also be differentiated by the ways they are managed.
Advisory account - You pay someone else to make buy and sell decisions on your behalf.
Wrap account - All the expenses associated with your account are “wrapped” into a single fee.
Discretionary account - You authorize your broker to trade for you.
Asset management account - Provide for complete money management, including check-writing privileges, credit cards, and margin loans.

46. Other Account Issues, II.
To invest in financial securities, you do not need an account with a broker.
One alternative is to buy securities directly from the issuer.
Another alternative is to invest in mutual funds
Mutual funds: Combining or pooling the funds of a large group of investors.

47. Short selling stocks

48. Short Sales
An investor with a long position benefits from price increases.
Easy to understand
You buy today at $34, and sell later at $57, you profit!
Buy low, sell high
“Go long” means you buy.
An investor with a short position benefits from price decreases.
Also easy to understand
You sell today at $83, and buy later at $27, you profit.
Sell high, buy low
“Go short” means you sell.

49. Short Sales
Short Sale is a sale in which the seller does not actually own the security that is sold.
Borrow
shares
from
someone
Sell the
Shares
in the
market
Buy
From the
Return
the
Today
In the Future
“He who sells what isn’t his’n, must buy it back, or go to prison.”
Note that an investor who buys and owns shares of stock is said to be “long the stock” or to have a “long position.”

50. Short Sales Short sale requirements
There is an initial margin and a maintenance margin
After you sell the borrowed stock, the proceeds from the sale are credited to your account.
But, you cannot use them until you “cover” the short position.
If any dividends are paid on the stock while you have a short position, you must repay them.
The owner of the shares need NOT know that the shares have been lent to the short-seller.
If the owner wishes to sell the shares, the brokerage firm will simply borrow shares from another investor.

51. Short Sales Four items on the account balance sheet Proceeds from sale
Margin deposit
Short position
Account equity

52. Liabilities and Account Equity
Example: Short Sales, I.
You short 100 shares of Texas Instruments (TXN) at $30 per share.
Your broker has a 50% initial margin and a 40% maintenance margin on short sales.
The value of stock borrowed that will be sold short is: $30 × $100 = $3,000
Assets
Liabilities and Account Equity
Sale Proceeds
$ 3,000
Short Position
Initial Margin Deposit
$ 1,500
Account Equity
Total
$ 4,500

53. Example: Short Sales, II.
Texas Instrument stock price falls to $20 per share.
Sold at $30, value today is $20, so you are "ahead" by $10 per share, or $1,000.
Also, new margin: $2,500 / $2,000 = 125%
Assets
Liabilities and
Account Equity
Sale Proceeds
$ 3,000
Short Position
$ 2,000
Initial Margin Deposit
$ 1,500
$ 2,500
Total
$ 4,500

54. Example: Short Sales, III.
Texas Instruments stock price rises to $40 per share.
You sold short at $30, stock price is now $40, you are "behind" by $10 per share, or $1,000. (He who sells what isn’t his’n, must buy it back—or go to prison.)
Also: new margin = $500 / $4,000 = 12.5% < 40% Therefore, you are subject to a margin call.
Assets
Liabilities and
Account Equity
Sale Proceeds
$ 3,000
Short Position
$ 4,000
Initial Margin Deposit
$ 1,500 $
Total
$ 4,500

57. Finding P*
The more compact way to express this formula is P*=initial stock price (1+IM) / (1+MM)

58. More on Short Sales
Short interest is the amount of common stock held in short positions.
In practice, short selling is quite common and a substantial volume of stock sales are initiated by short sellers.
Note that with a short position, you may lose more than your total investment, as there is no theoretical limit to how high the stock price may rise.

59. Biggest Short Positions (from The Wall Street Journal)

60. Short Selling Report from The Wall Street Journal

61. Finding Actual Short Positions (from finance.yahoo.com)

62. Useful Internet Sites
(a reference for dispute resolution)
(a reference for short selling)
(a reference for short interest)
(a reference for building a portfolio—search the site for “Build your first stock portfolio”)
(a reference for opening a brokerage account)
(another reference for opening a brokerage account)
(a risk tolerance questionnaire from Merrill Lynch)
(a reference for current broker call money rate)
finance.yahoo.com (a reference for short sales on particular stocks)

63. Chapter Review Getting Started Brokerage Accounts Short Sales
Choosing a Broker
Online Brokers
Security Investors Protection Corporation
Broker-Customer Relations
Brokerage Accounts
Cash Accounts
Margin Accounts
A Note on Annualizing Returns
Hypothecation and Street Name Registration
Other Account Issues
Short Sales
Basics of a Short Sale
Some Details
Investor Objectives, Constraints, and Strategies
Risk and Return
Investor Constraints
Strategies and Policies

64. Cash held in a brokerage account is insured up to $100,000 by the FDIC.
A) True
B) False

65. Hypothecation is the pledging of securities as collateral for a loan.
A) True
B) False

66. You short sold $5,000 worth of stock. Your maximum loss is $5,000.
A) True
B) False

67. Online brokers:
A) became popular in the mid-1980's.
B) have effectively lowered the cost of trading.
C) place orders on your behalf.
D) face minimal competition.
E) never offer check-writing privileges or debit cards.

68. You open a brokerage account with $10,000 in cash
You open a brokerage account with $10,000 in cash. Subsequently, you purchase 1,000 shares of a stock at $16 a share on margin. Which one of the following account values is correct concerning your account position after the stock purchase?
A) margin loan of $10,000
B) total assets of $26,000
C) account equity of $10,000
D) total assets of $10,000
E) account equity of $6,000

69. The maximum maintenance margin that your broker might require on stock purchases is _____ percent.
D) 90
E) 100

70. You own 300 shares of stock which dropped drastically in value today down to $13.50 a share. You have a margin loan of $2,880. What is the amount of your margin call if the maintenance margin is 40 percent?
A) $0
B) $450
C) $950
D) $1,260
E) $3,150

71. Jonathan owned a bond for 3 months and realized a holding period return of 4.5 percent. Hallie owned a similar bond for 4 months and had a holding period return of 4.5 percent. Jonathan earned an effective annual rate of _____ percent and Hallie earned an effective annual rate of _____ percent.
A) 16.50; 12.25
B) 17.56; 13.13
C) 18.00; 13.50
D) 18.67; 13.87
E) 19.25; 14.12