CHAPTER 11 INVESTMENT PLANNING

© 2008 Thomson South-Western

CHAPTER 11

INVESTMENT PLANNING

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The Objectives & Rewards

Of Investing Investing—usually considered a long-term

activity. Future values and returns expected to increase through time.

Speculating—usually considered a short-term activity. Future values and returns highly uncertain.

Adequate insurance coverage and cash/savings are investment prerequisites

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How Do I Get Started?

Accumulate money by regularly allocating a portion of your earnings for investing—PAY YOURSELF FIRST!

Take advantage of automatic investment and dividend reinvestment programs.

While saving, learn as much as possible about investments and "play" trading.

Determine your financial objectives.

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What Are Your Investment Objectives?

Supplement current income— appropriate for retired persons

Save for major expenditures— such as college education, down payment on a home, or starting a business

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Shelter income from taxes—to preserve more of your earnings.

Save for retirement—to live comfortably in your "golden years."

What Are Your Investment Objectives?

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Coming Up With the Capital

How much money will it take? Do you have a lump sum to invest now,

or will you systematically save toward your goal?

Your investment plan provides direction in helping you attain your goal

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Average Annual Returns On Stocks, Bonds, And U.S. T-bills Over Various Holding Periods From 5 - 15 Years

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Different Ways to Invest

1. Common Stock

2. Bonds

3. Preferreds and Convertibles

4. Mutual Funds

5. Real Estate

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1. Common Stock– Represents a share of ownership in a company.– Greater potential returns, but at a higher level of

risk.

2. Bonds– Represent the debt of a company.– Provide current income. – Lower level of risk than stocks, but with lower

expected returns as well.– Bond valuations inversely related to changes in

prevailing interest rates.

Different Ways to Invest

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3. Preferred Stock– An equity security that behaves like debt—provides

current income and possible price appreciation.– However, company has no legal obligation to

declare dividends.Convertible Bonds– Usually offer lower interest rates than regular

bonds, but —– Can be converted into common stock.– Risk that common stock will not do well and

investor simply gets lower return.

Different Ways to Invest

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– Collection of professionally managed securities offered by an investment company.

– Returns and level of risk depend on characteristics of underlying portfolio.

5. Real Estate– Can invest directly or through buying shares

of a REIT. – Estimating risk and expected return can be

difficult. Investors must be aware of economic cycles.

4. Mutual Funds

Different Ways to Invest

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Securities Markets

Securities market: place (not always physical) where financial instruments are traded.– Capital market—where long-term

securities (with maturities greater than 1 year) are traded.

– Money market—where low-risk, short-term securities (with maturities less than 1 year) are traded.

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Secondary market—for trading previously issued securities. – Securities exchanges– NASDAQ– OTC Market

Primary market—for new issues which are available for the very first time. – Investment bank underwrites– Issuing company gets proceeds– Prospectus

Securities Markets

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Dealer market— the buyer and seller are never brought together directly; their buy/sell orders are executed separately through securities dealers, who act as market makers

Broker market— the two sides to the transaction, the buyer and the seller, are brought together and the trade takes place at that point: the seller, Party A, sells securities directly to the buyer, Party B.

Broker and Dealer Markets

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Broker and Dealer Markets

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Bid price— the price at which a security can be sold

Ask price — the price at which a security can be bought

Dealer Markets

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– Organized securities exchanges exist in more than 100 countries worldwide.

– Found in major industrialized nations such as Japan, Great Britain, Germany and Canada.

– Also found in emerging economies around the globe.

Foreign Securities Markets

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Federal and state laws regulate the sale of securities.

Purpose is to provide for adequate and accurate disclosure of financial information.

Securities and Exchange Commission (SEC) is the agency in charge of administering federal securities laws.

Regulating the Securities Markets

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Securities Act of 1933 Securities Exchange Act of 1934 Investment Company Act of 1940 The Sarbanes-Oxley Act of 2002 Others:

– Maloney Act of 1938• Created the NASD

– The Securities Investor Protection Act of 1970• Created the SIPC

Regulating the Securities Markets

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Bull market—generally rising securities prices for an extended period of time.– Reflects investor optimism.– Associated with favorable economy.

Bear market—generally falling securities prices for an extended period of time.– Reflects investor pessimism.– Associated with economic downturn.

Market Trends

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Making Transactions In the Securities Markets - Stockbrokers

Stockbrokers (account executives, financial consultants) buy and sell securities for investors.

Investor can select from full-service, discount, or online broker

Brokerage services Consider brokerage fees when making

securities transactions.

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Types of Brokers

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Brokerage Fees

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Odd or Round Lots

ODD LOT: A quantity of fewer than 100 shares of a stock.– Odd-lot dealer– Odd-lot differential

ROUND LOT: A quantity of 100 shares of stock, or multiples thereof.

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Securities Investor Protection Corp. (SIPC) protects customer accounts against financial failure of brokerage firm

SIPC insures accounts up to $500,000 Guarantees securities or cash held by

broker will be replaced (does not guarantee dollar value of securities)

Arbitration used to settle disputes between brokerage firm and clients

Investor Protection

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Executing Trades

Investor must first establish account with broker.

Trades can be executed by phone, at the brokerage firm, or online.

Market orders generally take less than two minutes!

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Investor placesthe order with the broker.

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Investor placesthe order with the broker.

Broker transmitsorder to the market via tele-communications equipment.

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Investor placesthe order with the broker.

Broker transmitsorder to the market via tele-communications equipment.

Order isfilled at themarket byother buyersand sellers.

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Investor placesthe order with the broker.

Broker transmitsorder to the market via tele-communications equipment.

Order isfilled at themarket byother buyersand sellers.

Execution ofthe order isconfirmedto the broker.

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Investor placesthe order with the broker.

Broker transmitsorder to the market via tele-communications equipment.

Order isfilled at themarket byother buyersand sellers.

Execution ofthe order isconfirmedto the broker.

Broker confirms order fulfillment. Investor has 3 days to settle account.

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Types of Orders

Market order—trade now at best available price.

Limit order—trade when a specified price or better is reached; investor is seeking opportunity.

Stop-loss order—sell if price drops to certain price; investor is seeking to limit losses.

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Margin Trading and Short Sales

Buying on Margin: allows investor to purchase securities on credit by borrowing part of purchase price from broker.

Increases gains when returns are positive.

Increases losses when returns are negative.

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Short Sale Transactions

Allows investor to sell securities borrowed from the broker or broker's accounts.

Before period is over, investor must replace the borrowed securities.

Investor loses if security’s price has increased.

Investor profits if security’s price has declined.

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To profit from short selling: Not only must the price of the security fall, but it must do so within the given time period.

Short Sale Transactions

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Becoming an Informed Investor

Types of information to follow:

– Economic developments and current events

– Alternative investment vehicles

– Current interest rates and price quotations

– Personal investment strategies

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Available Investment Information

Annual Reports Financial Press

(WSJ and financial magazines) Brokerage Reports Advisory Services Investment Advisors On-Line Resources

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Annual Stockholder Reports

Read the Highlights or Selected Financial Data sections

CEO’s letter to stockholders Discussion of operations in

management’s discussion and analysis section

Review financial statements and notes

Read the auditor’s report

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Financial Press

Economic data Market data

– DJIA

– S&P indexes

– NYSE, NASDAQ, and other market indexes

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Financial Press

Industry data Company data Stock quotes

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Other Sources

Brokerage reports Subscription advisory services Investment advisors

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Analyst Reports

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Online Investing

Online services Educational

material Investment

tools– Investment

planning

– Research and screening

– Portfolio tracking

Day trading

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Tips for Successful Online Trades

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Managing Your Investment Holdings

Build a diversified portfolio of securities based upon your goals and personal situation.

Allocate your assets according to your objectives.

Track your investments and rebalance your portfolio as your needs change.

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Types of Investments Held by Average Individual Investors

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Investor Characteristics

Level and stability of income Family factors Investment horizon Net worth Investment experience and age Disposition toward risk

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Investor Objectives

Trade-off between earning a high current income from an investment and

Obtaining significant capital appreciation from it.

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Asset Allocation and Portfolio Management

How to divide portfolio among different types of securities

Total return on a portfolio is influenced far more by its asset allocation plan than by specific security selections.

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Asset Allocation and Portfolio Management

Asset mix:

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Asset Allocation and Portfolio Management

Reevaluate asset allocations regularly, especially when:– A major change in personal

circumstances– Proportion of an asset rises or fall

considerably– You’re close to reaching a particular

goal

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Keeping Track of Investments