CHAPTER 20 Understanding Personal Finances and Investments 20.1 A WORD FROM THE AUTHORS We regard this chapter as a complement to Chapter 19, “Mastering Financial Management,” because the money for financing business firms is derived largely from the investments of individuals. We begin by emphasizing the importance of managing personal finances, budgeting, and establishing specific investment objectives. Then we discuss the steps needed to establish an investment program. Next, we examine the role of an investment banking firm. We follow by outlining the steps in a typical stock transaction, noting the functions of a brokerage firm and the importance of choosing a full-service account executive or a discount broker. We also discuss the legal environment of securities trading. The investment alternatives discussed throughout the chapter are measured against five factors: safety, risk, income, liquidity, and growth. We consider traditional forms of investment, some of which were introduced in earlier chapters; these include bank accounts, corporate and government bonds, common and preferred stock, mutual funds, and real estate. We then discuss high-risk investment vehicles: buying stock on margin, selling short, and other high-risk investments. We conclude by examining sources of financial information including the Internet, newspapers, and other sources of information that can be used to evaluate investment alternatives. 20.2 TRANSITION GUIDE New in Chapter 20: Understanding Personal Finances and Investments • There are three revised learning objectives that describe the reorganization for this chapter: 1. Learning objective number 4 explains the reasons why people choose conservative investments including bank accounts, government bonds, and corporate bonds. 2. Learning objective number 5 identifies the advantages and disadvantages of stocks, mutual funds, real estate, and more speculative investments. 3. Learning objective number 7 describes how different investments are bought and sold. This material was revised and is now the last section in the chapter before the end-of-chapter materials. In the eleventh edition, it was the third major section in the chapter. • A new Inside Business feature, “The Vanguard Group Thinks Low-Cost and High-Tech,” has been included. • A new Ethical Success or Failure? feature discusses whether or not investors should buy green bonds. • A new Career Success feature explains how to obtain a license to trade in the securities industry. • In the “Step 2: Developing a Budget that Works” section, students are directed to the Mint.com and Motley Fool Web sites for help in managing their personal finances. • The Career Success feature, “It Is Never Too Early to Think About Retirement,” has been deleted. • New material on the relationship between careers and funding an investment program has been included in the section “Investment Goals.” • A new Personal Apps reinforces the need for students to develop personal, professional, and investment goals. • In the “Monitoring the Value of Your Investment Program” section, new material on the ups and downs of the financial markets illustrates the need to evaluate investments. Also, this section now includes a definition for the Dow Jones Industrial Average. • The rate of return example for Home Depot has been revised in the section “Safety and Risk.” • Monster Beverage, Adobe Systems, Questcor Pharmaceuticals, and Silicon Motion Technology are new examples of growth companies in the “Investment Growth” section. • The material in the section, “How Securities Are Bought and Sold,” has been moved to the last section in the chapter and now follows the material on different types of investments and the section on investment information. • Table 20.2, “Investment Alternatives,” has been revised and now includes three categories: Traditional Investments, More Speculative Investments, and The Most Speculative Investments. • The “Portfolio Management” section now includes a definition for the Standard and Poor’s 500 Stock Index. • The Spotlight feature, “The More You Make the More You Can Invest,” has been deleted. • Learning Objective 4 and the material in the “Conservative Investment Alternatives” section now describes bank accounts, government bonds, and corporate bonds. • The section, “Government Bonds,” now provides information about the relationship between the national debt and the risk associated with bonds and securities issued by the United States. • A new Table 20.3, “Information about U.S. Government Securities,” summarizes information about Treasury bills, Treasury notes, Treasury bonds, Treasury inflation-protected securities, and savings bonds. • A new example of a convertible Advanced Micro Devices bond has been illustrated in the “Convertible Corporate Bonds” section. • Learning Objective 5 and the “More Speculative Investments” section now provides information about common stock, preferred stock, mutual funds, real estate, and the most speculative investments techniques. • In the “Dividend Payments” section, information about Kraft Foods’ dividend policies has been provided. • A new example about how an investor made money by investing in Kellogg stock has been provided in the “Increase in Dollar Value” section and Table 20.4. • A new example about the Estée Lauder two-for-one stock split has been included in the section “Stock Splits.” • A new Sustaining the Planet feature describes green investing options. • In the section, “Mutual-Fund Charges and Fees,” students are referred to the SEC Web site for more information about fees and charges. • The Ethical Challenges & Successful Solutions feature, “Balancing Returns with Social Responsibility,” has been deleted. • “The Most Speculative Investment Techniques” section has been revised and shortened. • A new Table 20.6 provides information about five Web sites that can help students obtain investment information and establish an investment program. • A new Personal Apps stresses the importance of evaluating an investment before investing money. • Material on professional advisory services is now discussed before the material on financial and newspaper coverage. • A new Figure 20.1, “Mergent’s Research Report for Dollar Tree, Inc.,” provides information about Dollar Tree, Inc. • Figure 20.2 (stock quotes from the Wall Street Journal), Figure 20.3 (bond quote from Yahoo! Finance), and Figure 20.4 (mutual-fund quotes from the Wall Street Journal) have all been updated to provide the most current information at the time of publication. • A new definition for “prospectus” is now included in the section “Corporate Reports.” • Learning Objective 7 and the “How Investments Are Bought and Sold” section have been revised and moved to the end of the chapter. • The example of a limit order now includes the current price of a share of Coca-Cola stock at the time of publication. • The “Commissions” section and Table 20.7 has been revised and now provide current information about commissions charged by online brokerage firms. • A new section, “Purchasing Mutual Funds, Real Estate, and Other Investments,” provides information on how to purchase funds, real estate, and other investments. • A new Return to Inside Business about the Vanguard Group has been included. • A new Video Case 20.1, “Taming the Debt Monster One Budget at a Time,” has been included. • A new Case 20.2 explains how Fidelity helps investors prepare for their financial future. • The Building Skills for Career Success section contains a new Social Media Exercise. • The Exploring the Internet feature in Building Skills for Career Success has been deleted. • A revised and updated end-of-part video case about Graeter’s has been included. 20.3 QUICK REFERENCE GUIDE Instructor Resource Location Transition Guide IM, pp. 781–783 Learning Objectives Textbook, p. 579; IM, p. 785 Brief Chapter Outline IM, pp. 785–786 Comprehensive Lecture Outline IM, pp. 786–804 Ethical Success or Failure? Invest in Green Bonds? Textbook, p. 589 Sustaining the Planet Green Investing Textbook, p. 593 Career Success You’ll Need a License to Trade Textbook, p. 603 Inside Business The Vanguard Group Thinks Low-Cost and High-Tech Textbook, p. 580 Return to Inside Business Textbook, p. 607 Questions and Suggested Answers, IM, p. 805 Marginal Key Terms List Textbook, p. 608 Review Questions Textbook, p. 609 Questions and Suggested Answers, IM, pp.805–807 Discussion Questions Textbook, p. 609 Questions and Suggested Answers, IM, pp. 808–809 Video Case 20.1 (Taming the Debt Monster One Budget at a Time) and Questions Textbook, pp. 609–610 Questions and Suggested Answers, IM, pp. 809–810 Case 20.2 (Fidelity Helps Investors Prepare for Their Financial Future) and Questions Textbook, p. 610 Questions and Suggested Answers, IM, pp. 810–811 Building Skills for Career Success Textbook, pp. 611–612 Suggested Answers, IM, pp. 811–815 IM Quiz I & Quiz II IM, pp. 816–818 Answers, IM, p. 818 Classroom Exercises IM, pp. 819–820 20.4 LEARNING OBJECTIVES After studying this chapter, students should be able to: 1. Explain why you should manage your personal finances and develop a personal investment program. 2. Describe how the factors of safety, risk, income, growth, and liquidity affect your investment program. 3. Recognize how you can reduce investment risk and increase investment returns. 4. Explain the reasons people choose conservative investments including bank accounts and bonds. 5. Identify the advantages and disadvantages of stocks, mutual funds, real estate, and more speculative investments. 6. Use financial information to evaluate investment alternatives. 7. Understand how different investments are bought and sold. 20.5 BRIEF CHAPTER OUTLINE I. Managing Your Personal Finances A. Step 1: Tracking Your Income, Expenses, Assets, and Liabilities B. Step 2: Developing a Budget that Works C. Step 3: Managing Credit Card Debt D. Investment Goals E. A Personal Investment Program F. Monitoring the Value of Your Investment Program II. Important Factors in Personal Investment A. Safety and Risk B. Investment Income C. Investment Growth D. Investment Liquidity III. Factors that Can Improve Your Investment Decisions A. Portfolio Management B. Asset Allocation, the Time Factor, and Your Age 1. The Time Factor 2. Your Age C. Your Role in the Investment Process IV. Conservative Investment Alternatives A. Bank Accounts B. Corporate and Government Bonds 1. Government Bonds 2. Corporate Bonds 3. Convertible Corporate Bonds V. More Speculative Investments A. Common Stock 1. Dividend Payments 2. Increase in Dollar Value 3. Stock Splits B. Preferred Stock C. Mutual Funds and Exchange-Traded Funds 1. Mutual-Fund Basics 2. Mutual-Fund Sales Charges and Fees 3. Managed Funds Versus Indexed Funds 4. Types of Mutual-Fund Investments D. Real Estate E. The Most Speculative Investment Techniques 1. Selling Short 2. Buying Stock on Margin 3. Other High-Risk Investments VI. Sources of Financial Information A. The Internet B. Professional Advisory Services C. Financial Coverage of Securities Transactions 1. Common and Preferred Stocks 2. Bonds 3. Mutual Funds D. Other Sources of Financial Information 1. Brokerage Firm Analysts’ Reports 2. Business Periodicals 3. Corporate Reports E. Security Averages VII. How Investments Are Bought and Sold A. Purchasing Stocks and Bonds 1. Brokerage Firms and Account Executives 2. The Mechanics of a Transaction 3. Commissions B. Purchasing Mutual Funds, Real Estate, and Other Investments C. Regulation of Securities Trading 20.6 COMPREHENSIVE LECTURE OUTLINE I. Managing Your Personal Finances A. Step 1: Tracking Your Income, Expenses, Assets, and Liabilities 1. Many personal finance experts recommend that you begin the process of managing your money by determining your current financial condition. Often, the first step is to construct a personal income statement and balance sheet. a) A personal income statement lists your income and expenses for a specific period of time—usually a month. (1) By subtracting expenses from income, you can determine if you have a surplus or a deficit at the end of the time period. (2) Surplus funds can be used for savings, investing, or any purpose that you feel is important. (3) If you have a deficit, you must take action to reduce spending and pay down any debts you may have that will keep you from starting an investment program. b) A personal balance sheet lists your assets and liabilities on a specific date. (1) By subtracting your total liabilities from your total assets, you can determine your net worth. (2) For an individual, net worth is the difference between the value of your total assets and total liabilities. c) Based on the information contained in these two statements, you can determine your current financial condition and where you spend your money. B. Step 2: Developing a Budget that Works 1. A personal budget is a specific plan for spending your income. a) You begin by estimating your income for a specific period. b) The second step is to list expenses for the same period. c) It is important to balance your budget so that your income is equal to the money you spend, save, or invest each month. 2. After you have constructed your personal budget, you will need to compare the amounts included in your budget with your actual income and expenses. The goal is to have a surplus at the end of the budgeting period. 3. Like most personal financial planning, it will be necessary to review your budget on a regular basis. C. Step 3: Managing Credit Card Debt 1. Unfortunately, many individuals spend more than they make. Credit card purchases which have finance charges from 10 to 21 percent or more can be a problem. Credit card users should watch out for the following warning signs: a) Don’t fall behind on payments. b) Don’t use your credit cards to pay for many small purchases. They can add up to a surprise when you receive your statement at the end of the month. c) Don’t use the cash advance provision that accompanies most credit cards. The interest rate is usually higher than the credit card rate. d) Think about the number of cards you really need. e) Get help if you think you are in trouble. Teaching Tip: Ask students how many of them (or their parents) keep a personal budget. Follow up with a discussion of why such a budget would be useful. Sometimes students think that things like budgets are for people with significant income only. The spreadsheet-based team project “Personal Financial Management” exercise can be used here. D. Investment Goals 1. Personal investment is the use of your personal funds to earn a financial return. 2. In reality, an investment goal must be specific and measurable. a) It must be tailored to you so that it takes into account your particular financial needs. b) It must also be oriented toward the future because investing is usually a long-term undertaking. c) It must be realistic in terms of current economic conditions and available investment opportunities. d) Some financial planners suggest that investment goals be stated in terms of money. e) Others believe that people are more motivated to work toward goals that are stated in terms of the particular things they desire. f) The following questions can be helpful in establishing valid investment goals: (1) What financial goals do you want to achieve? (2) How much money will you need, and when? (3) What will you use the money for? (4) Is it reasonable to assume that you can obtain the amount of money you will need to meet your investment goals? (5) Do you expect your personal situation to change in a way that will affect your investment goals? (6) What economic conditions could alter your investment goals? (7) Are you willing to make the necessary sacrifices to ensure that your investment goals are met? Teaching Tip: At this point in their lives, most students are focused on college expenses and starting their careers. Most of them have not considered where they want to be at age 50. Ask students to take a couple of minutes and jot down five things they hope to own or do at age 50. Follow up with a discussion of what those “wants” indicate in terms of financial needs. They might be surprised how relatively easy it is to save for the future if they start early. E. A Personal Investment Program. Once you have formulated specific goals, investment planning is similar to planning for a business. 1. Investment planning begins with the evaluation of different investment opportunities—including the potential return and risk involved in each. a) This process requires some careful study and maybe some expert advice. b) Investors should be aware of people who call themselves “financial planners” but who are in reality nothing more than salespersons for various financial investments, tax shelters, or insurance plans. c) A true financial planner has had at least two years of training in investments, insurance, taxation, retirement planning, and estate planning and has passed a rigorous examination. (1) The Certified Financial Planners Board of Standards allows individuals to use the designation Certified Financial Planner (CFP). (2) Similarly, the American College in Bryn Mawr, Pennsylvania, allows individuals who have completed the necessary requirements to use the designation Chartered Financial Consultant (ChFC). 2. Many financial planners suggest that you begin an investment program by accumulating an “emergency fund”—a certain amount of money that can be obtained quickly in case of immediate need. The amount of money that should be salted away in the emergency fund varies, but most financial planners agree that an amount equal to three months’ living expenses is reasonable. 3. After the emergency account is established, you may invest additional funds according to your investment plan. (See Table 20.1.) F. Monitoring the Value of Your Investment Program 1. The Dow Jones Industrial Average is an average of 30 leading U.S. corporations that reflect the U.S. stock market as a whole. a) In the fall of 2007, it reached an all-time high at 14,000. By March 2009, it had declined to 6,600 as a result of the economic meltdown. b) Although the economy shows signs of improving (at the time of publication), a crisis could happen again. 2. Monitoring your investment program and re-evaluating your investment choices are always important, and the recent economic crisis underscores the importance of managing your personal finances and your personal investment program. II. Important Factors in Personal Investment. One way to determine which investments are “right” for an investment plan is to match potential investments with investment goals in terms of safety, risk, income, growth, and liquidity. A. Safety and Risk. Safety in an investment means minimal risk of loss; risk in an investment means a measure of uncertainty about the outcome. 1. For a steady increase in value, choose safe investments such as certificates of deposit, highly rated corporate and municipal bonds, and the stocks of highly regarded corporations sometimes called blue-chip stocks. A blue-chip stock is a safe investment that generally attracts conservative investors. 2. Selected mutual funds and real estate may also be very safe investments. 3. If you want higher dollar returns on your investments, you must generally give up some safety. a) In general, the potential return should be directly related to the assumed risk. That is, the greater the risk assumed, the greater the potential monetary reward should be. b) Without risk, it is impossible to obtain larger returns that really make your investment program grow. 4. Some investors often base their investment decision on projections for rate of return. To calculate rate of return, the total income you receive on an investment over a specific period of time is divided by the amount invested. a) The rate of return for different investment alternatives can be compared to determine which offer more or less risk. Teaching Tip: You may wish to show the brief video “Investing Money” here. This easy-to-understand video introduces the potential benefits of investing money in the context of taking risks. The Web site for this video is http://www.commoncraft.com/video/investing-money. B. Investment Income. Certificates of deposit, corporate and government bonds, and certain stocks pay a predictable amount of interest or dividends each year. 1. Some mutual funds also offer steady income potential. 2. Such investments are generally used by conservative investors who need a predictable source of income. 3. When purchasing investments for income, most investors are concerned about the issuer’s ability to continue making period interest or dividend payments. a) Investors in CDs and bonds know exactly how much income they will receive each year; dividends paid to stockholders can and do vary, and income from mutual funds and real estate may also vary from one year to the next. C. Investment Growth. To investors, growth means the investment will increase in value. 1. Some growing corporations usually pay a small cash dividend or no dividend at all. Instead, profits are reinvested to finance additional expansion. The value of the stock increases as the corporation expands. 2. Other investments that may offer growth potential include selected mutual funds and real estate. D. Investment Liquidity. Liquidity is the ease with which an asset can be converted into cash. 1. Investments range from cash or cash equivalents (such as investments in government securities or money market accounts) to the other extreme of frozen investments which you cannot easily convert into cash. 2. Although you may be able to sell other investments quickly, you might not regain the amount of money you originally invested because of market conditions, economic conditions, or many other reasons. III. Factors That Can Improve Your Investment Decisions. This section provides an overview of how portfolio management can reduce investment risk and the factors that you should consider to choose investments. Table 20.2 lists a number of investment alternatives. A. Portfolio Management 1. There are no easy answers when choosing the right investment because investment goals, age, tolerance for risk, and financial resources available for investment purposes are different for all. 2. Stocks have returned on average just below 10 percent per year. The Standard & Poor’s 500 Stock Index is an index that contains 500 different stocks that reflect increases or decreases in value for the U.S. stock market as a whole. 3. During the same period, U.S. government bonds have returned about 6 percent. 4. Stocks may have a place in every portfolio, but there is more to investing than just picking stocks or stock mutual funds. B. Asset Allocation, the Time Factor, and Your Age. Asset allocation is the process of spreading money among several types of investments to lessen risk. Asset allocation is often expressed in percentages. For example, what percentage of my assets do I want to put in stocks and mutual funds or more conservative investments such as CDs and government bonds? The answers to these questions are determined by: • The time your investments have to work for you • Your age • Your investment objectives • Your ability to tolerate risk • How much you can save and invest each year • The dollar value of your current investments • The economic outlook for the economy • Several other factors 1. The Time Factor. The amount of time you have before you need your investment money is crucial. a) If you can leave your investments alone and let them work for five to ten years or more, then you can invest in stocks, mutual funds, or real estate. b) If you need your investment money in two years, you should probably invest in short-term government bonds, highly rated corporate bonds, or certificates of deposit. By taking a more conservative approach for short-term investments, you reduce the possibility of having to sell your investments at a loss because of depressed market value or a staggering economy. c) On the other hand, many young investors with long-term investment goals could afford to hold their investments until the price of their securities recovered. 2. Your Age. You should also consider your age when developing an investment program. a) Younger investors tend to invest a large percentage of their nest egg in growth-oriented investments. b) Older investors tend to choose more conservative investments. c) To determine how much of your portfolio should be in growth-oriented investments, well-known personal financial expert Suze Orman suggests the following calculation: Subtract your age from 110, and the difference is the percentage of your assets that should be invested in growth investments. C. Your Role in the Investment Process. Investors want large returns, yet they are often unwilling to invest the time required to become a good investor. The following suggestions will help you choose investments that will increase in value. 1. Evaluate potential investments. Successful investors evaluate their investments before making investment decisions. 2. Monitor the value of your investments. This enables you to know if your investments have increased or decreased in value and if you should sell your investments or continue to hold them. 3. Keep accurate and current records. Accurate record keeping can help you spot opportunities to maximize profits, reduce dollar losses when you sell your investments, and help you decide whether to invest additional funds in a specific investment. a) For tax purposes, you should keep purchase records that include the actual dollar cost of the investment plus any commissions or fees you paid, along with records of dividends, interest income, or rental income you have received. Teaching Tip: Bring in a list of high-risk stocks and ask students how they would feel about investing in them. Use Google or another search engine to find the popular high-risk stocks of the day. IV. Conservative Investment Alternatives A. Bank Accounts. Bank accounts that pay interest—and are therefore investments—include passbook savings accounts, certificates of deposit, and interest-bearing accounts. 1. The interest paid on bank accounts can be withdrawn to serve as income, or it can be left on deposit and increase the value of the bank account and provide growth. 2. While CDs and other bank accounts are risk-free for practical purposes, many investors often choose other investments because of the potential for larger returns. B. Corporate and Government Bonds. In Chapter 19, we discussed the issuing of bonds by corporations to obtain financing. The U.S. government and state and local governments also issue bonds for the same reason. 1. Government Bonds. Despite concerns about the increasing dollar amount of the U.S. national debt, most investors still consider the nation’s government bonds to be risk-free. The other side of the coin is that these bonds pay lower interest than most other investments. a) Interest paid on U.S. government securities is taxable for federal income tax purposes, but is exempt from state and local taxation. b) Generally, investors choose from the five different types of U.S. government bonds and securities described in Table 20.3. c) Like the federal government, state and local governments sell bonds to obtain financing. A municipal bond is a debt security issued by a state or local government. (1) One of the most important features is that the interest on municipal bonds may be tax-exempt; it depends on how the funds obtained from their sale are used. d) Although municipal bonds are relatively safe, defaults have occurred in recent years. 2. Corporate Bonds. Because they are a form of long-term debt financing that must be repaid, bonds are generally considered a more conservative investment than either stocks or mutual funds. a) One of the principal advantages of corporate bonds is that they are primarily long-term, income-producing investments that pay interest—usually semi-annually. b) Most beginning investors think that a $1,000 bond is always worth $1,000. In reality, the price may fluctuate until its maturity date. When overall interest rates in the economy are rising, the market value of existing bonds typically declines. They then may be purchased for less than their face value. By holding the bond until maturity, bond owners can redeem the bond for more than they paid for it. c) A corporate bond with a fixed interest rate can also increase in value if overall interest rates in the economy decline. d) Before you invest in bonds, remember that the price of a corporate bond can decrease and that interest payments and eventual repayment may be a problem for a corporation that encounters financial difficulty. e) To compare potential risk and return on corporate bond issues, many investors rely on the bond ratings provided by Moody’s Investors Service, Inc., Fitch Ratings, and Standard & Poor’s Corporation. 3. Convertible Corporate Bonds. Some corporations prefer to issue convertible bonds because they carry a lower interest rate than nonconvertible bonds—by about 1 to 2 percent. a) In return for accepting a lower interest rate, owners of convertible bonds have the opportunity for increased investment growth because of the possibility of conversion to common stock. b) However, owners may opt not to convert their bonds to common stock. The reason for not exercising the conversion feature is quite simple. (1) As the market value of the common stock increases, the price of the convertible bond also increases. (2) By not converting to common stock, bondholders enjoy interest income from the bond in addition to the increased bond value caused by the price movement of the common stock. Teaching Tip: Use the group exercise “What to Do with My Bond” here. It will take approximately 20 minutes. V. More Speculative Investments. Before you examine more speculative investment alternatives, review the basic rule: the potential return should be directly related to the assumed risk. Additionally, keep in mind that dollar returns for the more speculative investments described are not guaranteed. A. Common Stock. Basically, there are three ways to make money by buying common stock: through dividend payments, through an increase in the value of the stock, or through stock splits. 1. Dividend Payments. One of the reasons why many stockholders invest in common stocks is dividend income. a) Although corporations are under no legal obligation to pay dividends, most board members like to keep stockholders happy (and prosperous). b) A corporation may pay stock dividends in place of—or in addition to—cash dividends. A stock dividend is a dividend in the form of additional stock. 2. Increase in Dollar Value. Another way to make money on stock investments is through capital gains. a) A capital gain is the difference between a security’s purchase price and its selling price. b) The market value of a stock is the price of one share of a stock at a particular time. c) A typical stock transaction for Kellogg is illustrated in Table 20.4. 3. Stock Splits. Directors of many corporations feel there is an optimal price range within which their firm’s stock is most attractive to investors. a) When the market value increases beyond that range, they may declare a stock split to bring the price down. A stock split is the division of each outstanding share of a corporation’s stock into a greater number of shares. b) The most common stock splits result in one, two, or three new shares for each original share. c) There are no guarantees that the stock will increase in value after a split. However, the stock is more attractive because of the potential for a rapid increase in dollar value. This attraction is based on the belief that most corporations split their stock only when their financial future is improving and on the upswing. B. Preferred Stock. A firm’s preferred stockholders must receive their dividends before common stockholders are paid any dividends. 1. The terms of payment of a preferred-stock dividend are specified on the stock certificate. 2. The owners of preferred stock have first claim, after bond owners and general creditors, on corporate assets if the firm is dissolved or enters bankruptcy. 3. Owners of preferred stock may gain through special features offered with certain stock issues. a) Owners of cumulative preferred stocks are assured that omitted dividends will be paid to them before common stockholders receive any dividends. b) Owners of convertible preferred stock may profit through growth as well as from dividends. When the value of a firm’s common stock increases, the market value of its convertible preferred stock also grows. Convertible preferred stock combines the lower risk of preferred stock with the possibility of greater speculative gain through conversion to common stock. C. Mutual Funds and Exchange-Traded Funds. A mutual fund combines and invests the funds of many investors—its shareholders—in a variety of different securities. The major advantages of a mutual fund are its professional management and its diversification, or investment in a wide variety of securities. 1. Mutual-Fund Basics a) The investment company sponsoring an open-end fund issues and sells new shares to any investors who requests them and buys back shares from investors who wish to sell all or part of their holdings. b) A closed-end fund sells shares in the fund to investors only when the fund is originally organized. Once all the shares are sold, an investor must purchase shares from some other investor who is willing to sell them. The investment company is under no obligation to buy back shares from investors. c) An exchange-traded fund (ETF) is a fund that invests in the stocks contained in a specific stock or securities index. (1) There are many different types of ETFs available that attempt to track all kinds of indexes including different types of stocks, bonds, and even commodities. (2) ETFs tend to mirror the performance of the specific index, moving up or down as the individual stocks or securities contained in the index move up or down. (3) Shares of an ETF are traded on a securities exchange or over-the-counter market any time during the business day. (4) Although ETFs are similar to closed-end funds, there is an important difference: Most closed-end funds are actively managed, with portfolio managers making the selection of stocks and securities contained in the fund. Almost all ETFs invest in the stocks, bonds, or securities included in a specific index, so there is less need for a portfolio manager to make investment decisions. Accordingly, fees are generally less. d) The share value for any mutual fund is determined by calculating its net asset value. Net asset value (NAV) per share is equal to the current market value of the mutual fund’s portfolio minus the mutual fund’s liabilities divided by the number of outstanding shares. 2. Mutual-Fund Sales Charges and Fees. There are two types of mutual funds: load and no-load funds. a) An individual who invests in a load fund pays a sales charge every time he or she purchases shares. This charge may be as high as 8.5 percent. b) Instead of charging investors a fee when they purchase shares in a mutual fund, some funds charge a contingent deferred sales fee that ranges from 1 to 5 percent of the amount withdrawn during the first five to seven years. (1) The amount of the contingent deferred sales fee declines each year that you own the fund until there is no withdrawal fee. c) The purchaser of shares in a no-load fund pays no sales charges at all. d) There is no significant performance difference between funds that charge load charges (commissions) and those that do not. e) Mutual funds collect a yearly management fee of about 0.25 to 1.5 percent of the total dollar amount of assets in the fund. f) Some mutual funds charge a 12b-1 fee (sometimes referred to as a distribution fee) to defray the costs of advertising and marketing a mutual fund. (1) Annual 12b-1 fees are calculated on the value of a fund’s assets and cannot exceed 1 percent of the fund’s assets. (2) The management fee and the 12b-1 fee are ongoing fees charged each year. (3) Together, all the different management fees, 12b-1 fees, and additional operating costs for a specific fund are referred to as an expense ratio. g) Mutual funds can be classified as A, B, or C shares. (1) With A shares, investors pay commissions when they purchase shares in the mutual fund. (2) With B shares, investors pay commissions when money is withdrawn or shares are sold during the first five to seven years. (3) With C shares, investors pay no commissions to buy or sell shares, but must pay higher ongoing management and 12b-1 fees. 3. Managed Funds Versus Indexed Funds. Most mutual funds are managed funds; i.e., there is a professional fund manager (or team of managers) who chooses the securities that are contained and decides when to buy and sell securities in the fund. a) Some investors choose to invest in an index fund rather than a managed fund. b) Over many years, index funds have outperformed managed funds. c) Because an index mutual fund is a mirror image of a specific index, the dollar value of a share in an index fund increases when the index increases; however, the reverse is also true. d) A second reason investors choose index funds is the lower expense ratio charged by these passively managed funds. 4. Types of Mutual-Fund Investments a) Mutual funds generally fall into three broad categories. (1) Stock funds, the majority of mutual funds, are issued by corporations that provide income, growth, or a combination of both. (2) Bond funds invest in corporate, government, or municipal bonds that provide investors with interest income. (3) Other funds stress asset allocation and money-market investments or strive for a balance between stocks and bonds. b) In most cases, the name of the category gives a pretty good clue to the type of investments included in the fund. • Aggressive growth stock funds • Balanced funds • Global stock funds • Growth stock funds • High-yield (junk) bond funds • Income stock funds • Index funds • Life cycle funds • Long-term U.S. bond funds • Regional funds • Sector stock funds • Socially responsible funds • Small-cap stock funds c) Most investment companies now allow shareholders to switch from one fund to another fund within the same family of funds. A family of funds exists when one investment company manages a group of mutual funds. D. Real Estate. Real estate ownership represents one of the best hedges against inflation but has its risks. 1. A piece of property in a poor location can decrease in value. 2. The real estate checklist in Table 20.5 cites many of the factors to consider. 3. Like any investment, real estate has disadvantages. a) The seller must find an interested buyer with the ability to obtain enough money to complete the transaction. This can be difficult if loan money is scarce, the real estate market is in a decline, or the seller overpaid for the property. b) If the seller is forced to hold the investment longer than originally planned, taxes and installment payments must also be considered. 4. The degree of success depends on how well the investor evaluates different alter-natives. Teaching Tip: Use the “My Personal Plan” individual class exercise here. Students should be given at least 30 minutes to complete the plan. If you plan to use this exercise, ask students in the class prior to the one in which the exercise is used to bring their texts or provide them with a list of potential investments. Alternately, the team-based “Personal Financial Management” spreadsheet exercise could also be used. E. The Most Speculative Investment Techniques. A high-risk investment is one made in the uncertain hope of earning a relatively large profit in a short time. (See The Most Speculative Investments category in Table 20.2.) Some investments become high-risk because of the methods used by investors to earn a quick profit. These methods can lead to large losses as well as to impressive gains and should not be used by anyone who does not fully understand the risks involved. 1. Selling Short. Normally, you buy stocks expecting that they will increase in value and then can be sold at a profit. This procedure is referred to as buying long. However, many securities decrease in value for various reasons. When this occurs, you can use a procedure called selling short to make a profit when the price of an individual stock is falling. Selling short is 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. The idea is to sell at today’s higher price and then buy later at a lower price. To make a profit from a short transaction, the investor must: a) Arrange to borrow a certain number of shares of a particular stock from a brokerage firm, and sell the borrowed stock immediately, assuming that its price will drop in a reasonably short time. b) After the price drops, buy the same number of shares that were “borrowed.” c) Give the newly purchased stock to the brokerage firm in return for the stock borrowed. Your profit is the difference between the amount received when the borrowed stock was sold and the amount paid for the stock. 2. Buying Stock on Margin. An investor buys stock on margin by borrowing part of the purchase price, usually from a stock brokerage firm. The margin requirement is the portion of the price of a stock that cannot be borrowed. This requirement is set by the Federal Reserve Board. a) The current margin requirement is 50 percent, which means you can borrow up to 50 percent of the cost of a stock purchase. b) Investors purchase stock on margin because they can purchase twice as much stock and earn more profit. c) The stock purchased on margin serves as collateral for the borrowed funds. d) Before you become a margin investor, consider two factors: (1) If the market price of the purchased stock does not increase as quickly as expected, interest costs mount and eventually drain your profit. (2) If the price of the margined stock falls, your dollar loss will be greater because you own more shares. e) If the value of a stock you bought on margin decreases to approximately 60 percent of its original price, you will receive a margin call from the brokerage firm. (1) You must then provide additional cash or securities to serve as collateral for the borrowed money. (2) If you cannot do so, the stock is sold, and the proceeds are used to pay off the loan. Any funds remaining after the loan is paid off are returned to you. 3. Other High-Risk Investments. Other high-risk investments include stock options, derivatives, commodities, precious metals, gemstones, coins, antiques, and collectibles. a) Without exception, investments of this kind are referred to as high-risk investments for one reason or another. b) Although investments in this category can lead to large dollar gains, they should not be used by anyone who does not fully understand all of the potential risks involved. Teaching Tip: Use the “We Won the Lottery!” group exercise here. Students should have approximately 20 to 30 minutes to do the exercise. VI. Sources of Financial Information. A wealth of information is available to investors from sources that include the Internet, newspapers, investors’ services, brokerage firm reports, business periodicals, corporate reports, and securities averages. A. The Internet 1. You can obtain interest rates for certificates of deposit; current price information for stocks, bonds, and mutual funds; and experts’ recommendations to buy, hold, or sell an investment. You can even trade securities online. 2. However, you need to use the Internet selectively. Search engines allow you to do a word search for the personal finance or investment alternative you want to explore. 3. Corporations, investment companies that sponsor mutual funds, and federal, state, and local governments also have home pages where you can obtain valuable information. 4. There are two reasons to explore the information available on the Internet: a) The information is readily accessible. b) The information may be more up-to-date than printed material obtained from published sources. 5. You can also access professional advisory services for information on stocks, bonds, mutual funds, and other investment alternatives. While some of the information provided by these services is free, there is a charge for more detailed information. B. Professional Advisory Services. For a fee, various professional advisory services provide information about investments. Information from these services may also be available at university and public libraries. 1. A number of professional advisory services provide detailed information on mutual funds. Although some information may be free, a fee is generally charged for more detailed research reports. 2. Various mutual-fund newsletters also supply financial information to subscribers for a fee. C. Financial Coverage of Securities Transactions. Many local newspapers carry several pages of business news, including reports of securities transactions. The Wall Street Journal and Barron’s are devoted almost entirely to financial and economic news. 1. Common and Preferred Stocks. Stock transactions are reported in tables that usually look like the top section of Figure 20.2. a) Move down the table to find the stock. To read the stock quotation, read across the table. Figure 20.2 gives detailed information about common stock issued by Aflac. 2. Bonds. Although some newspaper and financial publications provide limited information on certain corporate and government bond issues, it is usually easier to obtain more detailed information on a great number of bond issues by accessing the Internet. See Figure 20.3 for detailed information about an AT&T corporate bond. a) Bond prices are quoted as a percentage of the face value, which is usually $1,000. b) To find the actual price paid, you multiply the face value ($1,000) by the quotation listed in the newspaper. 3. Mutual Funds. Purchases and sales of mutual funds are reported in tables like the one shown in Figure 20.4. As in reading stock quotations, your first task is to move down the table to find the mutual fund in which you are interested and then read across the table to find the mutual-fund price quotation. D. Other Sources of Financial Information. Other sources, including professional advisory services, brokerage firm reports, business periodicals, and corporate reports, offer detailed and varied information about investment alternatives. 1. Brokerage Firm Analysts’ Reports. Brokerage firm reports are prepared by financial analysts and contain information on the corporation’s sales, profits and losses, management, and planning, plus other information on the company, its industry, demand for its products, its efforts to develop new products, and the current economic environment. a) The reports, which may include buy or sell recommendations, are usually provided free to clients of full-service brokerage firms. b) Reports may also be available from discount brokerage firms, although they may charge a fee. 2. Business Periodicals. Business magazines such as Bloomberg Businessweek, Fortune, and Forbes provide not only general economic news but also detailed financial information about individual corporations. a) These periodicals are available at libraries and are sold at newsstands and by subscription. b) Many of these periodicals sponsor an online Web site that may contain all or selected articles that are contained in the print version. 3. Corporate Reports. Publicly held corporations must publish annual reports which include a description of the company’s performance, information about the firm’s products or services, and detailed financial information that readers can use to evaluate the firm’s actual performance. a) In addition, a corporation issuing a new security must—by law—prepare a prospectus and ensure that copies are distributed to potential investors. A prospectus is a detailed, written description of a new security, the issuing corporation, and the corporation’s top management. b) A corporation’s prospectus and its annual and quarterly reports are available to the general public, either by requesting a copy by mail or telephone, or online. Go the corporation’s Web site and click on “Investor Relations.” E. Security Averages. Investors often gauge the stock market through the security averages reported in newspapers and on television news programs. A security average (or security index) is an average of the current market prices of selected securities. 1. Today, there are averages for stocks, mutual funds, bonds, mortgage rates, real estate, and most other investments. 2. Over a period of time, these averages indicate price trends, but they do not predict the performance of individual investments. At best, they can give the investor a “feel” for what is happening to investment prices. VII. How Investments Are Bought and Sold. We began this chapter by discussing why it is important to examine your current financial situation and the need to manage your money. Then we discussed the factors that influence your choice of investments, how successful investors are involved in the investment program, and conservative and speculative investment alternatives. Finally, we discussed how you can evaluate different investment alternatives in order to make an informed decision. Once you have researched a potential investment, you can use the options described next to buy or sell an investment. A. Purchasing Stocks and Bonds 1. Brokerage Firms and Account Executives. An account executive (sometimes called a stockbroker or registered representative) is an individual who buys or sells securities for clients. Before choosing an account executive, you should have already determined your investment goals and must then communicate these goals to the account executive. You must also decide whether you need a full-service broker or a discount broker. a) A full-service broker usually charges higher commissions when compared to a discount broker. You should consider how much help you need when making an investment decision. b) Many full-service brokerage firms argue that you need a professional to help you make important investment decisions; however, they may not be able to spend unlimited time with you on a one-to-one basis, especially if you are investing a small amount. c) On the other side, many discount brokerage firms argue that you alone are responsible for making your own investment decisions and they have both the personnel and research materials to help you become a better investor. Teaching Tip: Use the five-minute video from Tonka Beans’ educational video series, “How to Choose a Broker.” It discusses five key factors you need to consider before selecting a full-service or discount broker. The video is available at http://www.5min.com/Video/How-to-Choose-a-Broker-216478574. 2. The Mechanics of a Transaction. Once investors have decided on a particular security, most simply telephone their account executive and place a market or limit order. a) A market order is a request that a security be purchased or sold at the current market price. One method of executing a market order to sell a stock listed on the New York Stock Exchange (NYSE) at its current market value is illustrated in Figure 20.5. b) It is also possible for a brokerage firm to match a buy order for a security at one of its customers with a sell order for the same security from another of its customers. Match orders are not completed through a security exchange or the over-the-counter (OTC) market. c) A limit order is a request that a stock be bought or sold at a price equal to or better (lower for buying, higher for selling) than some specified price. Usually, a limit order is good for one day, one week, one month, or until cancelled. 3. Commissions. Most brokerage firms have a minimum commission ranging from $7 to $25 for buying and selling stock. Additional commission charges are based on the number of shares and the value of stock bought and sold. Table 20.7 shows typical commissions charged by online brokerage firms. a) As a rule of thumb, full-service brokerage firms charge as much as 1 to 2 percent of the transaction amount. b) Commissions for trading bonds, commodities, and options are usually lower than those for trading stocks. B. Purchasing Mutual Funds, Real Estate, and Other Investments 1. The method to buy or sell mutual funds depends on the type of fund you choose. Open-end funds can be purchased or sold directly from the investment company that sponsors the fund on any business day. Closed-end and exchange-traded funds can be purchased or sold on any business day through a securities exchange. a) The amount of sales charge also depends on the type of fund you purchase. For a load fund, the sales charge can be charged when you make a purchase or withdraw money from the fund. There is no sales charge for a no-load fund. b) When purchasing mutual-fund shares, you usually pay a commission to buy or sell shares, but not to buy and sell shares. 2. Although it is possible to buy or sell real estate without an agent or broker, these professionals are involved in most transactions, and she or he can provide professional advice, determine realistic market values, and help complete the transaction. You should expect to pay commissions when you sell a property. 3. A broker (or account executive) is usually involved in the purchase or sale of the most expensive speculative investment alternatives listed in Table 20.2. It is especially important to “know” the person you are dealing with when purchasing speculative investments because of the potential for fraud and misrepresentation. C. Regulation of Securities Trading. Government regulation of securities was begun as a response to abusive and fraudulent practices. Today, a regulatory pyramid consisting of four different levels exists to make sure that investors are protected. 1. The U.S. Congress is at the top of the pyramid. Congress passed the Securities Act of 1933, sometimes referred to as the Truth in Securities Act, which provides for full disclosure of important facts about stocks, bonds, and other securities so that investors can make informed decisions. Full disclosure means that investors should have access to all important facts about stocks, bonds, and other securities so that they can make informed decisions. a) This act also requires that corporations file a registration statement. b) Since 1933, Congress has passed additional legislation that includes creating the Securities Investor Protection Corporation (SIPC) to protect investors. c) Congress also passed legislation to curb insider trading, which occurs when insiders—board members, corporate managers, and employees—buy and sell a corporation’s stock. d) More recently, Congress passed the Sarbanes–Oxley Act to improve corporate accountability and financial reporting. 2. The Securities and Exchange Commission (SEC) is on the next level. The SEC enforces federal securities regulations and supervises all national exchanges, investment companies, OTC brokerage firms, and just about every other organization involved in trading securities. 3. Individual states are on the next level of the pyramid. a) Most states require that new security issues be registered with a state agency and that brokers and securities dealers operating within the state be licensed. b) Most state regulations also provide for the prosecution of individuals accused of the fraudulent sale of stocks, bonds, and other securities. 4. Self-regulation by securities exchanges and brokerage firms is the most important level of the regulatory pyramid. a) To provide guidelines of ethical behavior, the NYSE has published rules, policies, and standards of conduct. These standards are applied to every member in the NYSE’s investment community. b) The NYSE also conducts a thorough examination of each member firm that does business with the public at least once a year. Instructor Manual for Business William M. Pride, Robert J. Hughes, Jack R. Kapoor 9781133595854, 9780538478083, 9781285095158, 9781285555485, 9781133936671, 9781305037083
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