FIN330 Principles of Investing
University of North Carolina Wilmington
Cameron School of Business
Department of Economics & Finance
Principles of Investments
Finance 330
LECTURE NOTES AND STUDY GUIDE
Part 1: Chapters 1 - 4, 9, 10
To Accompany Hirt & Block’s
Fundamentals of Investment Management
10th Edition (2012), McGraw-Hill Irwin
[Or the 9th or 11th Edition]
Prepared by Dr. David P. Echevarria
 ALL RIGHTS RESERVED
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FIN330 Principles of Investing
CHAPTER 1
THE INVESTMENT SETTING
I.
STUDENT LEARNING OBJECTIVES
A. Why do people invest?
B. How do real assets differ from financial assets?
C. What is the relationship between risk and return?
D. Why are setting investment objectives important?
E. Why do people invest?
F. Accumulate funds for a particular purpose:
1. Wealth creation
a. Financial security
b. Retirement planning
G. Benefits to society and the economy
1. Capital formation
c. Job creation
d. Economic expansion
H. Real versus Financial Assets
I. Real Assets
1. Real estate: land, buildings
e. Equipment: machines, rolling stock
J. Financial Assets (claims against real assets)
1. Equities: Common and Preferred stock (ownership)
f. Fixed Income Securities: bills, notes, bonds (creditors)
K. Derivative Securities
1. Claims against financial assets
g. Used to hedge or to speculate
L. Risk versus Return
1. All investments are subject to risk
h. The greater the risk, the greater the expected return
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FIN330 Principles of Investing
i.
Risk = a probability distribution
j.
In finance, risk is defined as the standard deviation of expected future cash
flows
Problematically, we use recent market price volatility data to estimate future volatility
M. Setting investment objectives
1. Managing Risk: Diversification, Buy/Hold vs. Active Management
a. “I’m not so worried about the return on my money as I am the return of my
money.” -Will Rogers
k. Establishing Investment Objectives
l. Income or Capital Appreciation or Both
m. Wealth building phase: capital appreciation
n. Payout phase: Income and capital preservation
o. Expected Returns:
b. Function of risk tolerance: required risk premiums
c. Impact of inflation (net real returns)
p. Importance of Liquidity
q. Ease of buying and selling is very important
r. Illiquid securities more costly to buy and sell
s. Holding period - how long to hold [particular] investments
t. Short-term (less than one year)
u. Long-term (greater than one year)
v. Other considerations
w. Tax status
d. Marginal tax rate
e. Tax deferred investments
x. Personal time required to manage investments
f. Availability of time
g. Retaining a financial advisor
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FIN330 Principles of Investing
y. Investment management
z. Monitor performance
aa. Making adjustments through life stages
h. Changes in risk tolerance
i. Changes in investment goals
HOMEWORK ASSIGNMENT
A. Discussion Questions: 2, 5, 7, 11, 13
bb. Career Opportunities: Read Appendix 1A
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FIN330 Principles of Investing
II.
CHAPTER 2: SECURITY MARKETS
A. Student Learning Objectives
1. Primary functions of security markets
2. Primary, Secondary and Electronic Markets
3. Regulation of Security Markets
B. Primary Market Functions
1. Fair, open, and orderly trading
2. [Instant] Liquidity (low transaction costs)
3. Price (and Volume) information readily available
4. Market Efficiency: prices reflect all available information
C. Primary Markets
1. Investors buy new issues directly from sellers
a. At offering prices
b. By sealed bid (treasuries)
c. Investment Bankers
d. Financial intermediaries who get providers and demanders of capital
together (for a fee)
2. Help in pricing and issuing new securities
a. Bear risk of selling new securities (underwriting)
b. Distributes issue to the public (selling)
c. Investment Banking Functions
d. Advising: Timing, Pricing, Terms and Features
e. Underwriting: Full, Best Efforts
f. Distribution: Selling syndicate
g. Investment Banking
h. Initial Public Offerings (IPOs)
a. The first sale of common stock to the public
i.
Private Placements
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FIN330 Principles of Investing
j.
Private sale of securities directly to investors (Lettered stock)
k. Reduced liquidity - no secondary market
l. Secondary registration required to sell to public
m. Avoids underwriting discount (concession)
n. Avoids registration costs with SEC
D. Secondary Markets
1. Trade seasoned securities
a. Provide liquidity
b. Cost of liquidity services = bid-ask spread
c. Bid: the price # will pay to buy security
d. Ask: the price # will take to sell security
e. Participants: Market makers, Specialists, other traders (customers)
f. Spread size a function of risk and activity
g. Provide current price information
E. Types of Secondary Markets
1. Registered Exchanges
a. NYSE, AMEX, Regional exchanges
b. Trading by [open] auction or electronic
c. Over-the-Counter (OTC) markets
d. NASDAQ is primary player
e. Liquidity services more costly
f. Trading by computer (versus auction)
g. Most bonds traded OTC (Corps, Gov’ts, Muni's)
h. Electronic Communication Networks (ECN)
i.
Computerized systems that automatically match buy and sell orders
j.
Larger ECN’s owned the larger exchange systems: i.e., Archipelago
acquired by NYSE
F. Registered exchanges
1. New York Stock Exchange (NYSE): The “Big Board”
a. Stocks must meet listing requirements
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FIN330 Principles of Investing
b. Auction market
c. Only members can trade on the floor
d. More than 3000 issues actively traded
e. American Stock Exchange (AMEX)
f. Less stringent listing requirements
g. Smaller issues, Lower volumes
h. Less than 1000 issues actively traded.
i.
Recently acquired by Nasdaq
j.
Regional Exchanges
k. Five Major Regional Exchanges
l. Boston, Philadelphia, Cincinnati (NMS), Midwest, Pacific
m. Dual listing (regional & national exchanges)
n. Typically lower transaction costs than OTC
o. Different trading hours than NYSE, AMEX
p. Foreign Exchanges (Tokyo, London, Toronto, etc.)
G. Over-The-Counter
1. The NASDAQ Stock Market
a. National Association of Securities Dealers Automated Quotation system
b. Computer based system to serve OTC market for stocks
c. Gathers market makers together
d. Must have at least two market makers
e. Provides better pricing information
f. Less restrictive listing requirements
H. Regulation
1. SEC is primary regulatory agency
a. Securities Exchange Act of 1933: “information (prospectus) & registration
(w/ FTC - SEC)” requirements, penalties for misrepresentation
b. Securities Exchange Act of 1934: Required reports, insider trading activity,
Fed control of margin requirements
c. Securities Exchange Act of 1975: end of fixed commissions, established
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FIN330 Principles of Investing
NMS
d. Securities Act of 1940: Investment company act – Defines mutual fund
e. Securities Act of 1970:
(1) Established Securities Investor Protection Corporation [SIPC]
(2) Insures brokerage accounts up to $500,000
(3) Does not cover market losses
2. FINRA (formerly NASD) is a
a. Self-regulatory body for exchanges and broker/dealers
3. Some Recent Innovations
a. Circuit Breakers (1989): manage volatile markets
b. Program Trading: computer generated buy and sell points
I. HOMEWORK
1. Discussion Questions: 3, 4, 10, 12, 14
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FIN330 Principles of Investing
CHAPTER 3: PARTICIPATION IN THE MARKET
I. STUDENT LEARNING OBJECTIVES
A. Market Trading Characteristics
B. Full Service vs. Discount Brokers
C. Types of Accounts
D. Types of Orders
E. Measuring Investment Performance
III.
MARKET TRADING CHARACTERISTICS
A. Full service brokerage firm
1. Assigned broker - personalized service
2. Gives investment advice (research reports)
3. Executes orders
B. Discount broker
1. Executes orders
a. Lower commissions
b. Some investing advice/ideas (research reports)
C. Brokerage Accounts
1. Cash account
a. Pay full cost of all securities purchased
b. 3 business days settlement
“Investors must settle their security transactions in three business days. This settlement
cycle is known as "T+3" — shorthand for "trade date plus three days."
www.sec.gov/investor/pubs/tplus3.htm
2. Margin account
a. Finance portion of purchases (interest charges)
b. Short sellers must have a margin account
3. Order Types
a. Market Order
(1) Buy or sell at the best current price
(2) Settlement within three days
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FIN330 Principles of Investing
b. Limit Order
(1) Puts a limit on price
(2) Time period can vary: day, GTC
c. Stop [Loss] Order
(1) Becomes order if price reaches specified price
(2) No guarantee of execution at specified price
d. Trailing Stop Orders
A sell trailing stop order sets the stop price at a fixed amount below the market price
with an attached "trailing" amount. As the market price rises, the stop price rises by
the trail amount, but if the stock price falls, the stop loss price doesn't change, and a
market order is submitted when the stop price is hit. "Buy" trailing stop orders are the
mirror image of sell trailing stop orders, and are most appropriate for use in falling
markets. Source: http://www.interactivebrokers.com
D. Margin Accounts
1. Minimum required margin is 50% (equity)
2. Balance of purchase price loaned by broker
3. Margin % regulated by Federal Reserve
4. Maintenance margin is lower (typically 30%)
5. Margin call when equity drops below 30%
E. Long Position
1. Expectation - market heading higher
2. Purchase stock via market order at the Ask
3. Purchase stock via limit order at specified price
F. Selling Short
1. Expectation - market heading lower
2. Stock borrowed from broker
3. Profits on drop in prices (buy back at price lower than sell price)
G. Block trade
1. Purchase or sale of 10,000+ shares
2. NYSE Allows block trades away from floor
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FIN330 Principles of Investing
IV.
MARKET [HEALTH] INDICATORS
A. Dow Jones Industrial Average (DJIA): 30 largest industrials (price-weighted)
B. Standard & Poor’s 500 Stock Index (~ 75% of total stock market value) (value
weighted)
C. Bond Indexes: see Table 3-5
D. Mutual Fund Indexes: see Table 3-6 (Lipper)
V.
HOMEWORK
A. Discussion Questions: 1, 3, 4, 7, 11, 14, 15
B. Problems: 1, 5 (a, b, c), 12 (a, b, c)
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FIN330 Principles of Investing
CHAPTER 4: INVESTMENT COMPANIES
I.
STUDENT LEARNING OBJECTIVES
A. What are mutual funds, ETF’s, Net Asset Values (NAV)?
B. Type of Funds
C. Services Offered by Mutual Fund Companies
D. Selecting and evaluating mutual fund performance
E. Managing mutual fund investments
II.
MUTUAL FUNDS
A. Mutual funds pool funds from many investors to buy securities
B. Mutual funds have grown in importance
C. Open-end vs. Closed-End Funds
1. Open-ended mutual funds continually issue and redeem shares at NAV
2. Closed-end funds issue shares once. Investors must then sell (or buy) in
secondary markets
3. Net asset value (NAV) of a fund is the market value of the fund’s assets less
any liabilities, divided by the number of shares outstanding at that time
D. Advantages of mutual funds
1. Diversification
2. Smaller minimum investments to access large diversified portfolio
3. Professional management
E. Disadvantages of mutual funds
1. Most funds underperform relative to the S&P 500 Index
2. Fund expenses reduce returns
3. Too many to choose from – adverse selection problem
4. Many funds have minimum holding periods (to avoid trading fees / penalties)
F. Exchange Traded Funds (ETF’s)
1. Diversified portfolios of securities traded like ordinary stocks: they are
continuously market-to-market.
2. Portfolio objective similar to regular mutual funds: indexed, growth, income,
sector or country, international, emerging markets, etc.
G. Types of funds
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FIN330 Principles of Investing
1. Overall investment objectives
2. Growth, Income, Growth & Income, etc….
3. Types of securities purchased
a. Equity funds, money market funds, bonds
4. Load funds versus no-load funds
a. Load charges are assessed when shares are purchased (front-end) or sold
(back-end)
H. Services offered by mutual funds
1. Automatic reinvestment of distributions
2. Automatic investment plans
3. Check writing (money market funds)
4. Exchange privileges within fund families
5. Periodic statements
I. Selecting and evaluating mutual fund performance
1. Thousands of funds to select from
2. Setting investment goals
a. Income, capital appreciation, safety,
3. International/emerging markets
4. Assess fund risk metrics and historic returns before selecting
5. Evaluate services offered by the fund
6. Examine fees and expenses
7. Load charges and operating expenses
a. Contingent deferred sales charge is a back-end load that declines over time
b. Back-end loads discourage market timing by investors
c. Front-end loads compensate the broker
d. No-load funds dominate
e. Operating expenses: Measured as percent of NAV
(1) Management or advisory fees and other operating expenses
(2) Paid out of investment income
(3) 12b -1 fees cover distribution costs
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FIN330 Principles of Investing
(4) Compare loads and operating expenses for varying time periods in
evaluating funds
(5) No evidence that higher fees or load charges bring superior
performance
J. Unit investment trusts (UIT)
1. Most are pools of bonds: Corporates, Governments, Municipals
2. Investors looking for secure/known income (interest or dividends)
3. Fixed life of UIT minimizes interest rate risk
K. Evaluating historical performance
1. Performance is important criteria
2. Consider risk and return using standard deviation and beta to measure risk
3. Relative performance to a benchmark such as S&P 500 or average return of
mutual fund group
4. Consistency of performance over time
5. Assessing future performance
6. Past performance is a poor predictor since funds do not over the long term
post better risk-adjusted performance than the broad market averages
7. Others feel that past performance is a reasonable, though imperfect, predictor
because past performance reflects more than mere luck
a. Performance and taxes
b. Mutual funds are not taxed directly on income or capital gains as these are
passed on to the shareholders
c. Returns can be broken down into distributions and change in NAV
d. Portfolio turnover relates to higher capital gains distributions and
unrealized capital gains
e. Don’t purchase just before a distribution
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FIN330 Principles of Investing
L. Managing mutual fund investments
1. Passive versus active
2. Funds discourage market timing by imposing fees for frequent trading
3. Mutual funds are designed to be fairly long term investment vehicles
4. Investment objectives change through time
5. Dollar-cost averaging is investing equal dollar amounts at regular intervals
and can be beneficial when prices fluctuate but if prices continually rise,
buying more earlier is better
6. Rebalancing means adjusting a portfolio return to its target asset allocation
III.
HOMEWORK
A. Discussion Questions: 1, 3, 4, 5, 8, 12, 13, 15 (first part only)
B. Problems: 1, 5 (a, b, c), 8, 12 (a, b, c)
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FIN330 Principles of Investing
CHAPTER 9
MARKET EFFICIENCY: CONCEPT AND REALITY
I.
STUDENT LEARNING OBJECTIVES
A. What is the Efficient Markets Hypothesis? (EMH)
B. What are the implications of the EMH?
C. Are there different forms of the EMH?
D. How do we test for efficient markets?
E. What is the evidence for and against the EMH
II.
EFFICIENT MARKET HYPOTHESIS (EMH)
A. Prices fully reflect all available information
B. Prices adjust quickly to new information
C. Implications of the EMH
1. Information cannot be used to earn abnormal returns
2. Short-term price movements cannot be predicted - a random walk
3. Technical analysis is of no value even under weak-form EMH which requires
that either the patterns are mere illusions, or other investors would also
recognize any patterns
4. Fundamental analysis is only of value if one has superior forecasting skills
and can act before the market can react to new public information
5. Active portfolio management probably cannot outperform passive portfolio
management
6. Portfolio selection will depend upon risk preferences, age, income, etc….
D. Forms of E M H
1. Weak-form market efficiency: Current prices reflect all historical information
2. Semi-strong-form market efficiency: Prices fully reflect all public information
3. Strong-form market efficiency: Prices fully reflect all public and private
information
E. Strong-form Market Efficiency and Insider Trading
1. Even insiders cannot use private information to earn abnormal profits.
2. Moreover - Prohibited by law (1934 Act)
3. Insiders monitored by SEC and financial markets
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FIN330 Principles of Investing
F. Testing Market Efficiency
1. Types of tests
a. Historical (ex post)
b. Ex ante
2. Establish a benchmark (market portfolio)
3. Length and selection of time periods affects results (artifacts).
4. All tests are subject to criticism.
5. Roll’s Critique: knowledge of true market portfolio does not exist.
6. Qualitative versus quantitative efficiency
G. Evidence Against Market Efficiency
1. Calendar anomalies
a. January effect (Tax-Loss Selling in December)
b. Weekend effect
c. Small-firm effect
d. Stocks of small firms outperform large companies
2. Risk measure may not be adequate
3. Institutional investors overlook small firms
4. Performance of Investment Professionals
5. Value Line rankings
6. Fund Manager’s performance
H. Are Markets Efficient?
1. Some Evidence supports the EMH
a. More Evidence contradicts the EMH
b. Serial properties of economic data
c. Improvements in data mining
2. Cannot cover transaction expenses
3. Timing models inter-temporally unstable
III.
HOMEWORK
A. Questions: 1, 5, 7, 9, 12
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FIN330 Principles of Investing
CHAPTER 10
BEHAVIORAL FINANCE AND TECHNICAL ANALYSIS
I.
LEARNING OBJECTIVES
A. Understand how behavioral finance influences investment decisions.
B. Discuss how behavioral finance alters utility theory’s assumption of rational
behavior.
C. Appreciate how technical analysis is related to patterns of stock price movement.
D. Describe the contrary opinion rules and the smart money rules.
E. Discuss the key indicator series and its attempt to track the direction of the
market.
F. Distinguish between fundamental and technical analysis.
II.
BEHAVIORAL FINANCE
A. Examining the extent to which psychology influences our investment decisions:
behaving in unpredictable or irrational ways – differs from the general belief that
individuals are rational, end-of-period wealth maximizers.
B. Arguments against B.F.
1. Irrational behavior is a transient phenomenon – not general.
2. [Fama] Markets are efficient in that they incorporate all known information.
C. Arguments for B.F.
1. Anomalies suggest irrational behavior;
a. Calendar: end of year effect (tax loss selling), January effect, weekend
effect, etc.
b. Adequacy of traditional risk measures (~ standard deviation)
c. Recurrence of market bubbles suggestion irrational group behavior
2. Market analysts look to cognitive psychology as way to understand how
decisions are impacted by events.
a. Psychology: focuses on individual behavior vs. finance on collective
(average) behavior.
b. Social Psychology: how we make decisions in the presence of others.
c. Neurofinance: The functioning of the brain and how and why we make
choices.
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FIN330 Principles of Investing
3. Heuristics (Approaches to Problem Solving)
a. Representativeness: making judgments about the probability of an event
under uncertainty
b. Availability: mental shortcut that relies on immediate examples that come
to a given person's mind when evaluating a specific topic, concept, method
or decision.
c. Anchoring-and-Adjustment: basing estimates and decisions on known
‘anchors’ or familiar positions, with an adjustment relative to this start
point. We are better at relative thinking than absolute thinking.
d. Prospect Theory: tendency towards loss aversion. Utility of wealth depends
on deviations from moving reference points rather than absolute points.
e. Overreaction: responding more strongly than is necessary or appropriate.
f. Other Behavioral Issues: Overconfidence in forecasts, hindsight bias, selfattribution (taking credit for good outcomes – blaming others for bad
outcomes).
III.
TECHNICAL ANALYSIS
A. A method of evaluating securities by analyzing statistics generated by market
activity, such as past prices and volume. Technical analysts do not attempt to
measure a security's intrinsic value, but instead use charts and other tools to
identify patterns that can suggest future activity. (Investopedia.com)
B. The Use of Charting
4. Momentum: Price * Share Volume
5. Candles Sticks:
Clear = Close > Open
[Price higher]
Shaded: Open > Close
[Price lower]
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FIN330 Principles of Investing
6. Point and Figure: X = price up, 0 = price down
C. Essential Elements of the Dow Theory
1. Price discounts everything (similar to strong and semi-strong form theory)
2. Price movements are not totally random - trending (Burton Malkiel suggests
that price movements are random: See “A Random Walk Down Wall Street.”).
3. “What” is more important than “Why”: Technicians see price as the battle
between supply and demand for a company’s stock. Fundamentalists attempt
to explain why prices are moving (responding to value-relevant information).
D. Support and Resistance Levels: When prices move within a confined range.
Breakouts are important indicators of new trends.
E. Key Indicator Series
1. Contrary Opinion Rules:
The idea that when the vast majority of people agree on anything, they are
usually wrong. Contrarians swim against the tide. It’s really a psychological
concept, removed from the numerical constraints of fundamental and
technical analysis.
2. Smart Money Rules
Cash invested or wagered by those considered to be experienced, wellinformed, "in-the-know" or all three. Although there is little empirical
evidence to support the notion that smart-money investments perform any
better than non-smart-money investments do, many speculation methods take
such influxes of cash very seriously
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FIN330 Principles of Investing
3. Overall Market Rules per Warren Buffet
a. A stock is a business, not a piece of paper
b. Stocks serve as inflation protection over the long haul
c. Volatility is not risk
d. Keep a multi-decade time horizon
e. Keep an eye on fees, and use index funds
IV.
FUNDAMENTAL ANALYSIS
A. Using Quantitative Analysis to understand value implications of;
1. Balance Sheets: Assets, Liabilities, Equity
2. Income Statements: Revenues, Expenses (especially trends or significant
changes.
3. Statement of Cash Flows: Where did the cash come from? Where did it go?
B. Fundamental analysis serves to answer questions:
1. Is revenue growing? Growth rate versus national economy; faster, slower?
2. Is company earning economic profits? E.g. covering the opportunity cost of
capital.
3. How is it doing versus competition? Is it gaining, losing, or maintaining
market share?
4. How much of the assets are finance by debt? Is ability to service debt
impaired?
5. Do the numbers look right? Difficulty in determining if management is
cooking the books.
C. Some Qualitative Issues (less tangible factors)
1. What is the quality of board members and key executives?
2. Does the company have brand-name recognition?
3. Do they have patents or other proprietary technology that gives them a
competitive edge?
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FIN330 Principles of Investing
D. The Ultimate Challenge
1. Determining intrinsic value: what is the real value of the enterprise?
a. If you determine it is undervalued – BUY
b. If you determine it is overvalued – SELL
2. In the long run stock price reflects the fundamental value of the business.
E. Critics of Fundamental Analysis
1. Technical Analysts: Only price and volume are important
2. Believers in Efficient Markets Hypothesis: prices reflect all known
information. Nothing you can do will allow you to earn abnormal riskadjusted returns.
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