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Chapter 11 Investment Planning How Will This Affect Me? Investing is the means by which many important financial goals in life are achieved. This chapter discusses how to determine the amount of investment capital is needed to reach common financial goals and explains how to invest for retirement, to fund major expenditures, to earn needed income, and to establish tax shelters. The market context in which investing occurs is described, and how to buy and sell investments is explained. A framework for evaluating investments is also presented, which includes how to describe, monitor, and manage a portfolio. Sources of investment information are discussed, as well as some of the useful investing tools available online. After reading this chapter you should be able to plan your investments to better meet your financial goals. Chapters 11, 12, and 13 are the most important in the text, at lease I think so. This chapter gives an overview of the way to invest, the terminology of investing, and the various exchanges where you invest. To get the most from the chapter, the students need to do some investing. Not with real money, but investing in real securities. Therefore, I suggest that you create teams of about four students each and “give” them $100,000 to manage for at least one month during the semester. The student can send an email to their “broker” to execute their trades. I suggest that you allow only trades at the end of day prices, the closing prices, and not trades during the day. You can assign one team to be the broker or if available, a student assistant can be the broker. The broker will have to keep record of various buys and sells. The teams can compare the value of their portfolio at the end of period and a winner declared. Perhaps you can give a prize such as a five dollar gift certificate at Wendy’s or McDonalds or wherever. To prevent students from just buying and holding the entire time, I would require trades once a week and portfolios of at least five companies. You could use a short period in the class once a week to ask what the students are investing in just to assess the level of interest and activity. And you may get an idea of where you will invest. Or not. Learning Objectives Investing is a key element of personal financial planning because it allows the individual to meet many of his or her long-term financial goals by saving and using the funds in such a way that an additional return is earned. Once the level of savings in nearly riskless assets reaches an amount that is sufficient for emergency and other short-term purposes, funds can be put into various forms of investments. To be a successful investor, you must understand the institutions, mechanisms, and procedures involved in making securities transactions. Without this knowledge it would be impossible for you to take advantage of the opportunities offered in the financial markets, which, in turn, can be of real help in achieving your personal financial goals. 11-1 Discuss the role that investing plays in the personal financial planning process and identify several different investment objectives. Investing is the long-term process of purchasing securities wherein stability of value and level of return are somewhat predictable. Speculating, on the other hand, is the short-term buying and selling of securities in which future value and expected return are highly uncertain How, then, do you get started? First, you need some money—not a lot; $500 to $1,000 will do. And remember, this is investment capital we’re talking about here—money you’ve accumulated above and beyond basic emergency savings. Investing starts with an objective: a particular financial goal you’d like to achieve within a certain period of time. Investment objectives include current income, saving for major expenditures, retirement funds, and tax shelters. There are many ways to invest, including stocks, bonds, convertibles, preferred stock, mutual funds, real estate, commodities, financial futures, and options. The yearly savings required to fund the target goal is computed as: Yearly savings = Future amount of money desired / Future value annuity factor. 11-2 Distinguish between primary and secondary markets, as well as between broker and dealer markets. In the primary market, new securities are sold to the public, and one party to the transaction is always the issuer. In contrast, previously issued (outstanding) securities are bought and sold in the secondary market, where the securities are “traded” between investors. For a summary of the broker and dealer markets, see Exhibit 11.1, U.S. Broker and Dealer Markets. 11-3 Explain the process of buying and selling securities and recognize the different types of orders. Most students will not be aware of the different types of orders. You can demonstrate the short sales and stop loss orders and discuss who the exchanges allow to execute such orders. The power point slides gives the basics of these types of orders. If you “play the game” the students will learn more about these orders. 11-4 Develop an appreciation of how various forms of investment information can lead to better investing skills and returns. The text has Value Line Investment Survey report on Apple. It would be good to project that report using a document camera or scan into a file and project to a screen so you can discuss the various ratios and statistics that are reported in the report. There is a lot of information. 11-5 Gain a basic understanding of the impact of the Internet on the field of investments. The Internet provides individual investors access to discount brokers as well as to investment services, information, and tools to better select and monitor their own portfolios. The students may know more than the instructor about this. I would spend little time on the importance of the internet. 11-6 Describe an investment portfolio and how you’d go about developing, monitoring, and managing a portfolio of securities. While you most likely do not want to discuss portfolio theory, the concept of not “having all of your eggs in one basket” is intuitive and worthy of your time. I believe that with a volatile market, a portfolio approach is even more useful. The importance of comparing the value of your portfolio with the previous quarter’s [at least, if not monthly] is valuable and the students need to understand the information to be gain from such comparisons. I suggest you spend some class time explaining the importance of knowing how you are doing with your investments. Financial Facts or Fantasies? These may be used as “teasers” to get the students on the right page with you. Also, they may be used as quizzes after you covered the material or as “pre-test questions” to get their attention. Stocks listed on the New York Stock Exchange are traded in the over-the-counter market. Fantasy: Stocks not listed on organized exchanges are traded in the over-the-counter (OTC) market. Listed securities are traded on stock exchanges, which are not part of the OTC market. • If you lose a lot of money because a broker gave you a poor investment recommendation, you can recover most or all of your loss by filing a claim with the Securities Investor Protection Corporation. Fantasy: SIPC insurance applies only if you are dealing with a brokerage firm that goes out of business. If the brokerage firm fails, you are protected against the loss of securities or cash held by the broker. Importantly, that has nothing to do with getting bad advice from a broker; the SIPC does not cover such situations. • An aggressive investor would short sell a stock if he or she expects its price to go down. Fact: Short sales are made in anticipation of a drop in the price of a security; an investor makes money on a short sale when prices decline. However, selling short is quite risky and should only be done by risk-hardy, well-informed investors. • You should pay little attention to annual stockholders’ reports because they are so biased. Fantasy: While they do tend to accentuate the positive, annual stockholders’ reports are nonetheless an excellent source of information and are widely used by informed investors to obtain financial information about specific companies. • Coming up with a sound asset allocation plan will likely have more of an impact on long-term investment return than the specific securities you hold in your portfolio. Fact: Research shows that, over the long-run, the total return on a portfolio is influenced more by its asset allocation plan – its mix of assets – than by specific security selections. Financial Facts or Fantasies? These may be used as a quiz or as a pre-test to get the students interested. 1. True False Stocks listed on the New York Stock Exchange are traded in the over-the- counter market. 2. True False If you lose a lot of money because a broker gave you a poor investment recommendation, you can recover most or all of your loss by filing a claim with the Securities Investor Protection Corporation. 3. True False An aggressive investor would short sell a stock if he or she expects its price to go down. 4. True False You should pay little attention to annual stockholders’ reports because they are so biased. 5. True False Coming up with a sound asset allocation plan will likely have more of an impact on long-term investment return than the specific securities you hold in your portfolio. Answers 1. False 2. False 3. True 4. False 5. True Financial Planning Exercises 1. Calculate amount to invest to meet objectives. Use Worksheet 11.1 Phoebe Jones is now employed as the managing editor of a well-known business journal. Although she thoroughly enjoys her job and the people she works with, what she would really like to do is open a bookstore of her own. She would like to open her store in about eight years and figures she’ll need about $50,000 in capital to do so. Given that Phoebe thinks she can make about 10 percent on her money, use Worksheet 11.1 to answer the following questions. a. How much would Alison have to invest today, in one lump sum, to end up with $50,000 in eight years? See Worksheet 11.1 on next page. PV of 1= 1/(1 + .10)^8 = .466507; PV 50,000 = 50,000 * .488507 = $23,325.37 If Alison invest $23,325.37 at 10% for 8 years, she will have $50,000 at the end of 8 years. Using a financial calculator:
50,000 +/- FV
8 N
10 I/YR
PV $23,325.37
b. If she’s starting from scratch, how much would she have to put away annually to accumulate the needed capital in eight years? Using a financial calculator:
50,000 +/- FV
8 N
10 I/YR
PMT $4,372.20
c. How about if she already has $10,000 socked away; how much would she have to put away annually to accumulate the required capital in eight years? Using a financial calculator:
50,000 +/- FV
10,000 PV
8 N
10 I/YR
PMT $2,497.76
d. Given that Alison has an idea of how much she needs to save, briefly explain how she could use an investment plan to help reach her objective. An investment plan is a statement, preferably written, that sets out how capital will be invested to reach the financial goal. Once Alison decides on a course of capital accumulation, she must choose an investment plan outlining how she will invest to earn the ten percent she requires. Once she decides on the best investment vehicles, she must stick to the plan in order to ensure success. More specifically, what stock or bonds will she purchase in order to build her capital. 2. Rationale for stock exchange listings. Why do you suppose that large, well-known companies such as Apple, Starbucks, and Facebook prefer to have their shares traded on the NASDAQ rather than on one of the major listed exchanges, such as the NYSE (for which they’d easily meet all listing requirements)? What’s in it for them? What would they gain by switching over to the NYSE? The NYSE has the most stringent listing requirements of all the organized exchanges. There is a certain amount of prestige in being listed on the NYSE, because these companies have to have a certain minimum size market capitalization as well as meet certain profitability levels. If listed companies fall below these requirements, they stand to be delisted. However, even large, established companies that could easily meet these requirements may choose to stay on the NASDAQ instead. While the NYSE signals traditional standards, NASDAQ signals growth, vitality and innovation. According to NASDAQ's Web site, more companies now list on NASDAQ than all other major U.S. stock markets. It is the fastest growing major U.S. stock market and trades more shares per day than any other U.S. equities market. Many companies wish to tap into the energy generated by this environment. 3. Types of financial markets. What is the difference between primary and secondary markets and between broker and dealer markets? In the primary market, new securities are sold to the public, and one party to the transaction is always the issuer. Typically, an investment banker will arrange for a selling group to sell the new security. The selling group is normally made up of several brokerage firms, each responsible for selling a certain portion of the new issue In contrast, previously issued (outstanding) securities are bought and sold in the secondary market, where the securities are “traded” between investors. Probably the biggest difference in these two markets is how the trades are executed. When a trade occurs in a broker market (on one of the securities exchanges), then the two sides to the transaction—the buyer and the seller—are brought together and the trade takes place at that point: Party A sells his securities directly to the buyer, Party B. In a sense, with the help of a broker, the securities change hands right there on the floor of the exchange. In contrast, when trades are made in one of the dealer markets, the buyer and seller are never brought together directly; instead, their buy/sell orders are executed separately through securities dealers, who act as market makers. Essentially, two separate trades are made: Party A sells his securities (in, say, the XYZ Corp.) to one dealer, and Party B buys her securities (in the same XYZ Corp.) from the same or another dealer. Thus, there is always a dealer (market maker) on one side of the transaction. 4. Market and limit orders. Thomas Smith places an order to buy 100 shares of Google. Explain how the order will be processed if it’s a market order. Would it make any difference if it had been a limit order? Explain. The market order says to buy 100 shares at whatever the price is at that moment. The order is given to a broker and in due course, the stock is purchased. There will most likely be a lag between the order and the purchase. Thus, the purchase price may be different from the price at the time the order is placed. With limit order to buy, the order specifies the highest price to pay. If the stock is available for that price, the purchase will take place. If the stock is priced higher than the limit order, the stock will not be purchased. 5. Finding and applying market index quotes. Using resources like The Wall Street Journal or Barron’s (either in print or online), find the latest values for each of the following market averages and indexes, and indicate how each has performed over the past six months: The most direct approach is to search the internet for each term. The current value will typically be reported with an adjacent graph that may be expanded to six months. Following are the values on October 29, 2018 and for the range April 29 to October 29.
Index October 29, 2018 Six months ending Oct 28
a. DJIA 24,442.92 24,163 to 24,493
b. S&P 500 2,641.25 2,630 to 2,641
c. NASDAQ Composite 7,050.29 7,066 to 7.050
d. S&P Midcap 400 1,788.59 1,872 to 1,789
e. Dow Jones Wilshire 5000 27,228.07 27,521 to 27,228
f. Russell 2000: 1,477.31 1551 to 1477, a 4.19% drop
6. Obtaining stock market quotes. Using the Internet site for Yahoo! Finance (http://finance .yahoo.com), find the 52-week high and low for Coca-Cola’s common stock (symbol KO). What is the stock’s latest dividend yield? What was Coca-Cola’s most recent closing price, and at what P/E ratio was the stock trading?
Stock: Coca-Cola, symbol KO Information
52-week high 46.56
52-week low 41.45
dividend yield 3.40%
most recent closing price 45.92
P/E ratio 83.26 [wow]
7. Interpreting stock report information. Using the Value Line Investment Survey report in Exhibit 11.5, find the following information for Apple. a. What was the amount of revenues (i.e., sales) generated by the company in 2017? Revenue $229,234,000,000 b. What were the latest annual dividends per share and dividend yield? 2017 yearly dividend, $2.46, yield 1.8% c. What is the earnings per share (EPS) projection for 2019? 12.85 d. How many shares of common stock were outstanding? 4,915,138,000 e. What were the book value per share and EPS in 2017? Book value per share 2017 = 26.15 EPS 2017 = 9.21 f. How much long-term debt did the company have in the third quarter of 2018? 101,362 Million as of 3/31/2018: Projected for year end 2018 100,000 Million 8. Choosing an online broker. Based on Exhibit 11.3, which online broker do you believe would be best for you? Explain your rationale. For a new investor, I would suggest that “Customer service, education, and security” and “Costs” would be most important. I would place “Customer service, education, and security” as more important than cost. Therefore, I would select TD Ameritrade. There is little difference in the top 10. 9. Tracking portfolio performance. Use Worksheet 11.2 to help Max and Heidi Wood, a married couple in their early 30s, evaluate their securities portfolio, which includes these holdings. a. IBM. (NYSE; symbol IBM): 100 shares bought in 2011 for $170.40 per share. b. Procter & Gamble (NYSE; symbol PG): 150 shares purchased in 2010 at $61.85 per share. d. Google (NASDAQ; symbol, GOOG): 200 shares purchased in 2014 at $519.98 per share. e. The Woods also have $8,000 in a bank savings account that pays 1.25 percent annual interest. 1. Based on the latest quotes obtained from the Internet, complete Worksheet 11.2. 2. What’s the total amount the Woods have invested in these securities, the annual income they now receive, and the latest market value of their investments? 1. Worksheet 11.2 is below. If the stock has a stock dividend or stock split, the number of shares may have changed from what is listed. The overall return is computed by gain or loss from purchase to current market value plus income divided by purchase amount. For example, for IBM Rate of return = Ending value - Beginning value + Income / Beginning value ([11,964 – 17,040 = -5,076] + 628) / 17,040 = -26.10% overall return For the entire portfolio: (237,216 – 138,314 + 1,158.50) / 138,314 = 72.3%, note this is not an annual return, but a return over the entire period. To be more correct, the income should be for the same period of time as the time from the beginning value to the ending value. Better to compute these returns on an annual basis. 2. Total amount invested, $138,314 Annual Dividend and interest totaled $1,158,50. Latest, as October 29, 2018 market value is $237,216 YOU CAN DO IT NOW The “You Can Do It Now” cases may be assigned to the students as short cases or problems. They will help make the topic more real or relevant to the students. In most cases, it will only take about ten minutes to do, that is, until the student starts looking around at the web site. But they will learn by doing so. YOU CAN DO IT NOW How’s the Market Doing Right Now? It’s easy to find out how the stock market is doing anytime during trading hours as well as its performance so far during, the current year. For example, if you want to see how the S&P 500 index is doing, go to http://www.bloomberg.com/quote/SPX:IND. You’ll be able to see how the index is doing and if you look at the “year-to-date” section, you’ll see what the S&P 500 stocks have returned so far in this year. You can do it now. YOU CAN DO IT NOW Get a Quick Perspective on Your Asset Allocation The evidence shows that how much you invest in different asset classes – stocks vs. bonds vs. real estate and the like – is extremely important. Indeed, it’s more important than the particular securities in each asset class portfolio! It’s important to have a good perspective on your asset class decision. Good, rough recommendations can be found at http://www.bankrate.com/calculators/retirement/asset-allocation.aspx and https://personal.vanguard.com/us/funds/tools/recommendation. Just answer a few questions about your investment horizon and attitude towards risk and you’re set – you can do it YOU CAN DO IT NOW Track Your Portfolio for Free You can track your portfolio for free. And you can track a “paper” portfolio as well just to test out investment ideas. Just go to https://www.google.com/finance/portfolio?action=view – you can do it now. Financial Impact of Personal Choices Read and think about the choices being made. Do you agree or not? Ask the students to discuss the choices being made. Nancy and Elliot Get Serious About Their Retirement Asset Allocation Nancy and Elliot Kelly are married and are both 32 years old. While they want to save for their children’s future college educations, they also want to be plan carefully for their retirement. They know that it’s important to be adequately diversified and to be properly positioned in the various asset categories in their 401(k) retirement plans and IRAs. So one recent Saturday afternoon they found a free online asset allocation calculator (http://money.cnn.com/tools/assetallocwizard/assetallocwizard.html) and got some initial guidance on their proper asset allocation. The online survey asked them to about their investment time horizon, how much risk they were comfortable with, the flexibility of their retirement date, and whether they’re tempted to sell stocks during a downturn or buy more. They indicated a 20+ year investment time horizon, medium risk tolerance, flexible retirement dates, and an inclination to leave their investments alone during a downturn. The recommended asset allocation was: 10% bonds 50% large stocks 20% small stocks 20% foreign stocks Given that this recommends they invest 90% of their money in stocks, Nancy and Elliot have decided to get some more recommendations for a broad perspective on their asset allocation decision. This recommendation strikes them as a bit too risky for their tastes. However, this recommendation confirms their interest in having a significant amount invested in stocks with decent international diversification for the long haul. Nancy and Elliot are well on their way to managing their retirement investments effectively. Test Yourself 11-1 Briefly discuss the relationship between investing and personal financial planning. Investing is generally considered to take a long-term perspective and is viewed as a process of purchasing securities wherein stability of value and level of return are somewhat predictable. The best way to achieve financial objectives is through personal financial planning, which helps define our financial goals and develop appropriate strategies to reach them. To obtain financial goals requires long term planning that includes investments plans as well as debt management, retirement planning, insurance planning, career management, family planning, and all of the other financial planning activities. Investing is a major tool in providing the financial resources necessary to obtain your financial goals. 11-2 What’s the difference between an investment plan and a capital accumulation plan? Capital accumulation, which is saving, is necessary in order to have funds to invest. Investing is what you do with the capital you accumulate before you spend it to support your life style. 11-3 Why is it important to have investment objectives when embarking on an investment program? There are a wide variety of securities available for investing. Some provide annual income in the form of dividends. Other provide increase wealth but no dividends. Your goal for investing will guide you in your selection of alternative securities. 11-4 How does a primary market differ from a secondary market? Where are most securities traded: in the primary or the secondary market? In the primary market, new securities are sold to the public, and one party to the transaction is always the issuer. In contrast, old (outstanding) securities are bought and sold in the secondary market, where the securities are “traded” between investors. Securities are sold in the primary market only one time; they are sold many times in the secondary market. The volume of sales in the secondary market overwhelms that in the primary market. 11-5 What is the difference between the broker and dealer markets? Broker markets are the national and regional stock exchanges. At the stock exchange the buyer and seller meet and exchange the stock. The Dealer market does not have a central point where transactions are completed. A dealer may be anywhere and will offer a stock for sale at the ask price, while another dealer will offer to buy at a bid price. When the two prices are the same, a transaction takes place between the two dealers. The dealers may be trading for themselves or for others. 11-6 What are regional exchanges, and what role do they play? The regional exchanges operate much like the New York Stock Exchange. They have brokers who tend to focus on local or regional stock, but who also will offer stock listed on the NYSE. The listing requirements are more lenient than those of the NYSE, but since the stock being sold is from a regional company, the buyer presumably know more about the companies. 11-7 Describe the operations of the NASDAQ market. Compare it with an exchange, such as the NYSE. To be traded on NASDAQ, all stocks must have at least two market makers—although the bigger, more actively traded stocks (such as Apple) will have many more than that. These dealers electronically post all their bid/ask prices so that, when investors place (market) orders, they’re immediately filled at the best available price. With the broker market or the exchange, the buying and selling broker are at the exchange and strike a deal between them. The brokers typically will be buying and selling for other people. 11-8 Contrast the NASDAQ and National Market System with the OTCBB. NASDAQ sets various listing standards, the most comprehensive of which are for the 2,000 or so stocks traded on the NASDAQ National Market (NNM). The other part of the dealer market is made up of securities that trade in the over-the-counter (OTC) market. This market is separate from NASDAQ and includes mostly small companies that either can’t or don’t wish to comply with NASDAQ listing requirements. They trade on either the OTC Bulletin Board (OTCBB) or in the so-called Pink Sheets. The OTCBB is an electronic quotation system that links the market makers who trade the shares of small companies. The OTCBB is regulated by the Securities and Exchange Commission (SEC), which requires (among other things) that all companies traded on this market file audited financial statements and comply with federal securities law 11-9 Explain the difference between a bull market and a bear market. Discuss the frequency with which returns as bad as those during 2007–2009 occur. How would you characterize the current state of the stock market? Prices go up in bull markets; these favorable markets are normally associated with investor optimism, economic recovery, and growth. In contrast, prices go down in bear markets, which are normally associated with investor pessimism and economic slowdowns. Exhibit 11.2 reports the historical performance of U.S. stocks. The table shows that over the past 50 years there have been more bull markets than bear markets. In 2015, the market was volatile and most likely will end up as a bear market for the year. The previous three years have been bull markets. 11-10 Describe the role that discount brokers play in carrying out security transactions. To whom are their services especially appealing? In contrast, investors who simply want to execute trades and aren’t interested in obtaining all those brokerage services should consider either a discount broker or an online broker. Discount brokers tend to have low-overhead operations and offer fewer customer services than do full-service brokers. The full service brokers have repositioned themselves as money managers who buy and sell for their clients. Most stock transactions are handled by discount brokers. 11-11 What are online brokers, and what kinds of investors are most likely to use them? Again, most brokers have an online presence and low transaction fees. Investors who manage their own investments tend to use online broker services. Investors who use money managers to manage their investments do not use broker services directly. Their money managers do. 11-12 What is the SIPC, and how does it protect investors? As a client, you’re protected against the loss of securities or cash held by your broker by the Securities Investor Protection Corporation (SIPC), a nonprofit corporation authorized by the Securities Investor Protection Act of 1970 to protect customer accounts against the financial failure of a brokerage firm. Although subject to SEC and congressional oversight, the SIPC is not an agency of the U.S. government. SIPC insurance covers each account for up to $500,000 (of which up to $100,000 may be in cash balances held by the firm). Note, however, that SIPC insurance does not guarantee that the dollar value of the securities will be recovered. It ensures only that the securities themselves will be returned. 11-13 What is arbitration? Does SIPC require the use of arbitration in investor disputes? Arbitration is a process whereby you and your broker present the two sides of the argument before an arbitration panel, which then decides how the case will be resolved. If it’s binding arbitration, and it usually is, then you have no choice but to accept the decision—you cannot go to court to appeal your case. SIPC is not involved in disputes concerning the quality of service provided; this is the type of cases that arbitration panels hear. In fact, many brokerage firms require that you resolve disputes using binding arbitration. 11-14 Name and describe three basic types of orders. An order to buy or sell a security at the best price available at the time it’s placed is a market order. An order to buy at a specified price (or lower), or sell at a specified price (or higher) is known as a limit order. An order to sell a stock when the market price reaches or drops below a specified level is called a stop-loss, or stop order. 11-15 Why might an investor buy securities on margin? Buying on margin, as it’s called, is a practice that allows investors to use borrowed money to make security transactions. The use of margin allows you to increase the return on your investment when stock prices increase. 11-16 Describe how the return on an investment is calculated. Rate of return is the increase or decrease in the price of an investment as well as any income received over the investment period, both stated as a percentage of the initial investment. It is calculated as: Rate of Return = (Ending value - Beginning Value + Income)/(Beginning value) 11-17 What is a short sale? Explain the logic behind it. How much could be gained or lost on a short sale investment? A short sale transaction is made in anticipation of a decline in the price of a stock. When an investor sells a security short, the broker borrows the security and then sells it on behalf of the short seller’s account—short sellers actually sell securities they don’t own. The borrowed shares must, of course, be replaced in the future, and if the investor can repurchase the shares at a lower price, then a profit will result. 11-18 Briefly discuss the four basic types of information that you, as an investor, should follow. Here are the four types of investment information that you should follow on a regular basis: • Economic developments and current events: To help you evaluate the underlying investment environment • Alternative investment vehicles: To keep you abreast of market developments • Current interest rates and price quotations: To monitor your investments and stay alert for developing investment opportunities • Personal investment strategies: To help you hone your skills and stay alert for new techniques as they develop 11-19 What role do market averages and indexes play in the investment process? Usually presented in the form of averages, or indexes, market data describe the general behavior of the securities markets. The averages and indexes are based on the price movements of a select group of securities over an extended period. They’re used to capture the overall performance of the market as a whole. They also may be used as a standard to compare against your performance, that is, are you beating the market? Most likely not. 11-20 Briefly describe the DJIA, S&P 400, S&P 500, NASDAQ Composite, Russell 2000, and Dow Jones Wilshire 5000 indexes. Which segments of the market does each measure track? Dow Jones Industrial Average (DJIA). The Dow Jones averages, which began in 1896, are made up of four parts: (1) an industrial average, the DJIA, which is based on 30 stocks; (2) a transportation average based on 20 stocks; (3) a utility average based on 15 stocks; and (4) a composite average based on all 65 industrial, transportation, and utility stocks. A variation of the S&P discussed below is the Midcap 400 (made up of 400 medium-sized companies with market values ranging from about $1.4 billion to $5.9 billion). The Standard & Poor’s (S&P) indexes are similar to the Dow Jones averages in that both are used to capture the overall performance of the market. However, some important differences exist between the two measures. For one thing, the S&P uses a lot more stocks: the popular S&P 500 composite index is based on 500 different stocks, whereas the DJIA uses only 30. What’s more, the S&P index is made up of all large NYSE stocks in addition to some major AMEX and NASDAQ stocks, so there are not only more issues in the S&P sample but also a greater breadth of representation. Finally, there are some technical differences in the mathematical procedures used to compute the two measures; the Dow Jones is an average, whereas the S&P is an index. Behavior in the NASDAQ market is also measured by several indexes, the most comprehensive of which is the NASDAQ Composite index, which is calculated using virtually all the stocks traded on NASDAQ. A widely followed measure is the Russell 2000, which tracks the behavior of 2,000 relatively small companies and is widely considered to be a fairly accurate measure of the small-cap segment of the market. Besides these major indexes, there are a couple of other measures of market performance, one of which is the Dow Jones Wilshire 5000 index. It’s estimated that the Wilshire index reflects the total market value of 98 percent to 99 percent of all publicly traded stocks in the United States. In essence, it shows what’s happening in the stock market as a whole—the dollar amount of market value added or lost as the market moves up and down. 11-21 Describe the Internet’s impact on the world of investing. The Internet is a major force in the investing environment. It has opened the world of investing to individual investors, leveling the playing field and providing access to tools and market information formerly restricted to professionals. Not only can you trade all types of securities online, you can also find a wealth of information, from real-time stock quotes to securities analysts’ research reports. The internet adds access and speed to the investing process. 11-22 What are some products and services that you, as an individual investor, can now obtain online? Whatever there is, it is available online. Some commonly available stuff include brokerage services, reports, “heard on the street”, business news, and many other. Brands include CNN/Money, Yahoo.com, Fidelity.com, etc. 11-23 Briefly describe several types of online investment tools, and note how they can help you become a better investor. The Internet offers a wide array of tutorials, online classes, and articles to educate the novice investor. Even experienced investors will find sites that expand their investing knowledge. Although most good investment-oriented Web sites include many educational resources, here are a few good sites featuring investment fundamentals. • The Motley Fool (http://www.fool.com) Fool’s School has sections on fundamentals of investing, mutual fund investing, choosing a broker, investment strategies and styles, lively discussion boards, and more. • Morningstar (http://www.morningstar.com) provides comprehensive information on stocks, mutual funds, ETFs, and more. • Zacks Investment Research (http://www.zacks.com) is an excellent starting place to learn what the Internet can offer investors. • NASDAQ (http://www.nasdaq.com) has an Investor Resource section that helps with financial planning and choosing a broker. Other good educational sites include, as noted above, leading personal finance magazines like Money (http://money.cnn.com) and Kiplinger’s Personal Finance Magazine (http://www.kiplinger.com). 11-24 What is day trading, and how is it different from the more traditional approach to investing? The attraction of trading stocks online is so compelling that some investors have become day traders. The opposite of buy-and-hold investors with a long-term perspective, day traders buy and sell stocks quickly throughout the day. They hope their stocks will continue to rise in value for the short time they own them—sometimes just seconds or minutes—so they can make quick profits. 11-25 Explain why it might be preferable for a person to invest in a portfolio of securities rather than in a single security. Don’t put all your eggs in one basket. In essence, a portfolio is a collection of investment vehicles assembled to meet a common investment goal. But a portfolio is far more than a collection of investments. It breathes life into your investment program as it combines your personal and financial traits with your investment objectives to give some structure to your investments. Seasoned investors often devote much attention to constructing diversified portfolios of securities. Such portfolios consist of stocks and bonds selected not only for their returns but also for their combined risk–return behavior. The idea behind diversification is that, by combining securities with dissimilar risk–return characteristics, you can produce a portfolio of reduced risk and more predictable levels of return. 11-26 Briefly describe the concept of asset allocation and note how it works. The investor’s needs shape one’s financial goals. But to create a portfolio geared to those goals, you need to develop an asset allocation strategy. Asset allocation involves a decision on how to divide your portfolio among different types of securities. Typically you are dividing your investment between short-term securities such as money market funds, longer term bonds (7 to 10 year maturities, and equity funds invested in stocks for the long-term. 11-27 Discuss the role of asset allocation in portfolio management. There’s overwhelming evidence that, over the long run, the total return on a portfolio is influenced far more by its asset allocation plan than by specific security selections. Asset allocation deals in broad categories and does not tell you which individual securities to buy or sell. 11-28 What, if anything, can be gained from keeping track of your investment holdings? Knowledge is power. If you do not know how you are doing, you do not if you need to make a change in what you are doing. You need to monitor your portfolio by keeping track of what your investment holdings consist of, how they’ve performed over time, and whether they’ve lived up to your expectations. Critical Thinking Cases 11.1 The Woodson’s Struggle with Two Investment Goals Like many married couples, Damian and Brandi Woodson are trying their best to save for two important investment objectives: (1) an education fund to put their two children through college; and (2) a retirement nest egg for themselves. They want to have set aside $40,000 per child by the time each one starts college. Given that their children are now 10 and 12 years old, Damian and Brandi have 6 years remaining for one child and 8 for the other. As far as their retirement plans are concerned, the Woodson’s both hope to retire in 20 years, when they reach age 65. Both Damian and Brandi work, and together, they currently earn about $90,000 a year. Six years ago, the Woodson’s started a college fund by investing $6,000 a year in bank CDs. That fund is now worth $45,000—enough to put one child through an in-state college. They also have $50,000 that they received from an inheritance invested in several mutual funds and another $20,000 in a tax sheltered retirement account. Damian and Brandi believe that they’ll easily be able to continue putting away $6,000 a year for the next 20 years. In fact, Brandi thinks they’ll be able to put away even more, particularly after the children are out of school. The Woodson’s are fairly conservative investors and feel they can probably earn about 6 percent on their money. (Ignore taxes for the purpose of this exercise.) Critical Thinking Questions 1. Use Worksheet 11.1 to determine whether the Woodson’s have enough money right now to meet their children’s educational needs. That is, will the $45,000 they’ve accumulated so far be enough to put their children through school, given they can invest their money at 6 percent? Remember, they want to have $40,000 set aside for each child by the time each one starts college. The Woodson’s have a balance of $45,000 saved for the education fund. Assuming that the fund is split in half for each child, they need an additional $35,000. The present value of the amount they need for the educational fund is $53,283 of which they now have $45,000. Thus they need an additional $8,283 in the fund now. Assuming that the funds earn 6%, they could designate $8,283 of their mutual fund for use to pay for the second child education. Alternatively, they could use $1,770 of the $6,000 they save each year for the education fund and the balance for their retirement fund. If the education is a higher priority than their retirement fund, I suggest moving $8,283 from their retirement mutual fund to the education fund and then set about rebuilding their retirement fund.
Determining the Amount of Investment Capital
Financial Goal: To accumulate an additional $35,000 in 8 years Child 1 Child 2
1. Targeted Financial Goal (see Note 1) $40,000 $40,000
2. Projected Average Return on Investments 6% 6%
A. Finding a Lump Sum Investment: 3. Future Value Factor, from Appendix A based on _____6 or_8_____ years to target date and a projected average return on investment of ___6%_______ 1.419 1.594
4. Required Lump Sum Investment line 1 / line 3 $28,189 $25,094
B. Making a Series of Investments over Time: 5. Amount of Initial Investment, if any (see Note 2) 22,500 22,500
6. Future Value Factor, from Appendix A based on __6 or_8___ years of target date and a projected average return on investment of ___6%___ 1.419 1.594
7. Terminal Value of Initial Investment line 5 * line 6 $31,928 $35,865
8. Balance to Come from Savings Plan line 1- line 7 $9,428 $4,135
9. Future Value Annuity Factor, from Appendix B based on __6 or_8___ years to target date and a projected average return on investment of __6%____ 6.975 9.897
10. Series of Annual Investments Required over Time line 8 / line 9 $1,352 $418
Total $1,770
Note 1: The “targeted financial goal” is the amount of money you want to accumulate by some target date in the future.
Note 2: If you’re starting from scratch—i.e., there is no initial investment—enter zero on line 5, skip lines 6 and 7, and then use the total targeted financial goal (from line 1) as the amount to be funded
2. Regarding their retirement nest egg, assume that no additions are made to either the $50,000 they now have in mutual funds or to the $20,000 in the retirement account. How much would these investments be worth in 20 years, given that they can earn 6 percent? Using Appendix A, the future value of the two amounts will be: Mutual Funds: $50,000 * 3.207 = $160,350 Retirement account: $20,000 * 3.207 = $64,140 Using the financial calculator set on 1 P/YR and End Mode, these investments would be worth a total of $224,499.48 in 20 years, given a 6% investment rate.
Mutual Fund: Retirement Account:
50,000 +/- PV 20,000 +/- PV
6 I/YR 6 I/YR
20 N 20 N
FV $160,356.77 FV $64,142.71
3. Now, if the Woodson’s can invest $6,000 a year for the next 20 years and apply all of that to their retirement nest egg, how much would they be able to accumulate given their 6 percent rate of return? From appendix B, the annuity of $6,000 per year for 20 years at 6% will accumulate to 36.786 * 6,000 = $220,716. They currently have a total of $70,000 in their fund. That amount will accumulate to $224,490 (from 2 above). Thus, they would have a total of $445,206 in 20 years. 4. How do you think the Woodson’s are doing with regard to meeting their twin investment objectives? Explain. They will meet their goal for the educational fund. Their retirement fund is another matter. Assuming at least one lives for another 20 years after retirement, to fund an annuity of $90,000 per year [their current living costs], they will need a fund of $90,000 * 11.470 [from Appendix D] or a total of $1,032,300. They are $587,094 short. To accumulate the million the need, they will have to triple their savings to about $18,000 or increase the return on their investments. 11.2 Russ Alonzo Takes Stock of His Securities Russ Alonzo is 42 years old, single, and works as a designer for a major architectural firm. He is well paid and over time has built up a sizable portfolio of investments. He considers himself an aggressive investor and, because he has no dependents to worry about, likes to invest in high-risk/high-return securities. His records show the following information. 1. In 2006, Russ bought 200 shares of eBay (NASDAQ; symbol EBAY) at $29.77 a share. 2. In 2013 he bought 250 shares of Facebook (NYSE; symbol FB) at $26.89 a share. 3. In 2008, Russ bought 200 shares of United Technologies Corp. (NYSE; symbol UTX)) at $74.92 a share. 4. In early 2009, he bought 450 shares of JPMorgan Chase (NYSE; symbol JPM) at $16 a share. 5. Also in 2009, Russ bought 400 shares of Pepsico (NYSE; symbol PEP) at $52.50 a share. 6. He has $12,000 in a 1 percent money market mutual fund. Every three months or so Russ prepares a complete, up-to-date inventory of his investment holdings. Critical Thinking Questions 1. Use a form like Worksheet 11.2 to prepare a complete inventory of Russ’s investment holdings. (Note: Look in the latest issue of The Wall Street Journal, or pull up an online source such as http://finance.yahoo.com, to find the most recent closing price of the five stocks in Russ’s portfolio.)
An Inventory of Investment Holdings
Names Russ Alonzo Date August 28, 2015
Type of Investment Description of Investment Date Purchased Amount of Investment Overall Return Latest Market Value
Common Stock 200 sh, EBAY 2006 $5,954 -8.5% $5,450
Common Stock 250 sh, FB 2013 $6,722 238% $22,752
Common Stock 200 sh, UTX 2008 $14,984 24.5% $18,648
Common Stock 450 sh, JPM 2009 $7,200 301% $28,858
Common Stock 400 sh, PEP 2009 $21,000 78.2% $37,412
Saving Acct, Bank Rate 1.00 $12,000 $12,000
Totals $67,860 84.4% $125,120
2. What is your overall assessment of Russ’s investment portfolio? Does it appear that his personal net worth is improving because of his investments? Russ has done some better than the market as a whole. From 2010 to August 28, 2015, the DJIA increase 66%. Russ has overall return of 84%. He is improving his net worth. 3. Based on the worksheet you prepared in Question 1, do you see any securities that you think Russ should consider selling? What other investment advice might you give Russ? He should review EBAY and UTX [United Technology]. These two stock are not performing as well as his other stock. Of course the past is the past, his decision to sell or not will be based on his evaluation of the future. Terms Found in the Chapter
annual stockholders’ report A report made available to stockholders and other interested parties that includes a variety of financial and descriptive information about a firm’s operations in the recent past.
arbitration A procedure used to settle disputes between a brokerage firm and its clients; both sides present their positions to a board of arbitration, which makes a final and often binding decision on the matter.
ask price The price at which one can purchase a security.
asset allocation A plan for dividing a portfolio among different classes of securities in order to preserve capital by protecting the portfolio against negative market developments.
bid price The price at which one can sell a security.
bear market A condition of the market typically associated with investor pessimism and economic slowdown; characterized by generally falling securities prices.
bull market A market condition normally associated with investor optimism, economic recovery, and expansion; characterized by generally rising securities prices.
day trader An investor who buys and sells stocks (and other securities) rapidly throughout the day in hopes of making quick profits.
discount broker A broker with low overhead who charges low commissions and offers little or no services to investors.
diversification The process of choosing securities with dissimilar risk–return characteristics in order to create a portfolio that provides an acceptable level of return and an acceptable exposure to risk.
Dow Jones Industrial Average (DJIA) The most widely followed measure of stock market performance; consists of 30 blue-chip stocks listed mostly on NYSE.
Dow Jones Wilshire 5000 index An index of the total market value of the approximately 6,000–7,000 most actively traded stocks in the United States.
full-service broker A broker who, in addition to executing clients’ transactions, offers a full array of brokerage services.
investing The process of placing money in some medium such as stocks or bonds in the expectation of receiving some future benefit
investment plan A statement—preferably written—that specifies how investment capital will be invested to achieve a specified goal.
limit order An order to either buy a security at a specified or lower price or to sell a security at or above a specified price.
market order An order to buy or sell a security at the best price available at the time it is placed.
National Association of Securities Dealers (NASD) An agency made up of brokers and dealers in over-the-counter securities that regulates OTC market operations.
NYSE index An index of the performance of all stocks listed on the New York Stock Exchange.
odd lot A quantity of fewer than 100 shares of a stock.
online broker Typically a discount broker through which investors can execute trades electronically/ online through a commercial service or on the Internet; also called Internet broker or electronic broker.
portfolio A collection of securities assembled for the purpose of meeting common investment goals.
prospectus A document made available to prospective security buyers that describes the firm and a new security issue.
risk averse The average investor’s attitude toward risk is such that, when presented with two investments having the same expected return, the one with the lowest risk will be chosen.
rate of return The increase or decrease in the price of an investment as well as any income received over the investment period, both stated as a percentage of the initial investment.
round lot A quantity of 100 shares of stock, or multiples thereof.
Securities and Exchange Commission (SEC) An agency of the federal government that regulates the disclosure of information about securities and generally oversees the operation of securities exchanges and markets.
Securities Investor Protection Corporation (SIPC) A nonprofit corporation, created by Congress and subject to SEC and congressional oversight that insures customer accounts against the financial failure of a brokerage firm.
securities markets The marketplace in which stocks, bonds, and other financial instruments are traded.
short sale A transaction that involves selling borrowed securities with the expectation that they can be replaced at a lower price at some future date; made in anticipation of a decline in the security’s price.
speculating A form of investing in which future value and expected returns are highly uncertain.
Standard & Poor’s (S&P) indexes Indexes compiled by Standard & Poor’s that are similar to the DJIA but employ different computational methods and consist of far more stocks.
stockbroker (account executive, financial consultant) A person who buys and sells securities on behalf of clients and gives them investment advice and information.
stop-loss (stop order) An order to sell a stock when the market price reaches or drops below a specified level.
Investment Planning Chapter Outline Learning Objectives I. The Objectives and Rewards of Investing A. How Do I Get Started? B. The Role of Investing in Personal Financial Planning 1. Coming Up With the Capital 2. An Investment Plan Provides Direction C. What Are Your Investment Objectives? 1. Current Income 2. Major Expenditures 3. Retirement 4. Shelter from Taxes D. Different Ways to Invest 1. Common Stock 2. Bonds 3. Preferred and Convertibles 4. Mutual Funds, Exchange Traded Funds, and Exchange Traded Notes 5. Real Estate II. Securities Markets A. Primary and Secondary Markets 1. Primary Markets 2. Secondary Markets B. Broker Markets and Dealer Markets 1. Broker Markets 2. Dealer Markets C. Foreign Securities Markets D. Regulating the Securities Markets E. Bull Market or Bear? III. Making Transactions in the Securities Markets A. Stockbrokers 1. Selecting a Broker 2. Full-Service, Discount, and Online Brokers 3. Brokerage Fees 4. Investor Protection B. Executing Trades C. Types of Orders 1. Market Order 2. Limit Order 3. Stop-Loss Order D. Margin Trades and Short Sales IV. Becoming an Informed Investor A. Annual Stockholders' Reports B. The Financial Press 1. Market Data a. Dow Jones Industrial Averages b. Standard & Poor's Indexes c. The NYSE, NASDAQ, and Other Market Indexes 2. Industry Data 3. Company Data 4. Stock Quotes C. Brokerage Reports D. Advisory Services V. Online Investing A. Online Investor Services 1. Investor Education 2. Investment Tools a. Investment Planning b. Investment Research and Screening c. Portfolio Tracking VI. Managing Your Investment Holdings A. Building a Portfolio of Securities 1. Investor Characteristics 2. Investor Objectives B. Asset Allocation and Portfolio Management C. Keeping Track of Your Investments Solution Manual for Personal Finance Michael Joehnk , Randall Billingsley , Lawrence Gitman
