Chapter Twenty-One Understanding Securities Markets and Investments

Chapter Twenty-One

Understanding Securities Markets and Investments

Copyright © Houghton Mifflin Company. All rights reserved. 21 - 2

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, www.nyse.com, February 9, 2003.



• 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



• 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



• 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



• 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



• 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 – LiabilitiesNumber 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



• 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– www.bloomberg.com– http://money.cnn.com– www.financecenter.com– www.fool.com– www.quicken.com– www.sec.gov– http://finance.yahoo.com

• Newspaper coverage of securities transactions– Common and preferred stocks– Bonds– Mutual funds

http://www.bloomberg.com/

http://money.cnn.com/

http://www.financecenter.com/

http://www.fool.com/

http://www.quicken.com/

http://www.sec.gov/

http://finance.yahoo.com/


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

Documents

Chapter Twenty-One Understanding Securities Markets and Investments