Chapter
2
The Investment
Process
Learning Objectives
Don’t sell yourself short. Instead, learn about these key
investment subjects:
1. The various types of securities brokers and brokerage accounts.
2. How to calculate initial and maintenance margin for investing on
margin.
3. The workings of short sales.
4. The importance of investor objectives, constraints, and strategies.
2-2
FORMING AN INVESTMENT
PORTFOLIO
2-3
Investment Objectives
• Fundamental Question: Why invest at all?
– We invest today to have more tomorrow.
– Investment is simply deferred consumption.
– We choose to wait because we want more to spend later.
• In formulating investment objectives, the individual must
balance return objectives with risk tolerance.
– Investors must think about risk and return.
– Investors must think about how much risk they can handle.
2-4
Investment Strategies and Policies
• Investment management. Should you manage your investments
yourself?
• Market timing. Should you try to buy and sell in anticipation of the
future direction of the market?
• Asset allocation. How should you distribute your investment funds
across the different classes of assets?
• Security selection. Within each class, which specific securities
should you buy?
2-5
Asset Allocation or Security Selection?
•
Is asset allocation or security selection more important to the success of
a portfolio?
•
Most people are inclined to think security selection is the more important
element for successful investing.
•
Research shows, however, that asset allocation is the more important
determinant of portfolio returns. Many experts suggest:
– About 90 percent of portfolio performance stems from asset allocation.
– So, 10 percent of portfolio performance comes from security selection.
•
How is this result possible? Well, consider the Crash of 2008.
– Bonds outperformed stocks in 2008
– Even those elusive “skilled stock pickers” might underperform bonds
•
•
Stocks tend to move together
Even a “skilled stock picker” would have trouble beating bonds if most stock prices are performing
poorly relative to bond prices
2-7
Investor Constraints
• Resources. What is the minimum sum needed? What are the
associated costs?
• Horizon. When do you need the money?
• Liquidity. How high is the possibility that you need to sell the asset
quickly?
• Taxes. Which tax bracket are you in?
• Special circumstances. Does your company provide any incentive?
What are your regulatory and legal restrictions?
2-8
Forming a Real Investment Portfolio, I.
• Take the Risk Tolerance Quiz in the textbook.
• What score did you get?
2-9
Forming a Real Investment Portfolio, II.
• What does your score mean?
2-10
TAXES IN INVESTING
DECISIONS
2-11
Taxes in Investing Decisions
• “It’s not what you make, it’s what you keep that is
important.”
• Tax Planning Involves:
– The desired return after-taxes
– Type of income received from investments
– Timing of profit-taking and loss recognition
1-12
Taxes in Investing Decisions (cont'd)
• Types of Income for Individuals
– Ordinary income
• Taxed at progressive tax rates (rates go up as income goes up)
• Active, portfolio and passive income included
– Active Income: income from working (wages,
salaries, pensions)
– Portfolio Income: income from investments (interest, dividends,
capital gains)
– Passive Income: income from special investments (rents from
real estate, royalties, limited partnerships)
– Capital Gains and Losses
• Capital Asset: property owned and used by taxpayer, including
securities and personal residence
• Capital Gain: amount by which the proceeds from the sale of a
capital asset are more than its original purchase price
• Capital Loss: amount by which the proceeds from the sale of a
capital asset are less than its original purchase price
1-13
Tax Rates and Income Brackets for Individual and
Joint Returns (2006 and 2012)
50
Taxes in Investing Decisions (cont'd)
• Taxation of Capital Gains
– Capital assets held less than one year: ordinary income tax
rates
– Capital assets held more than one year: 0% or 15%, depending
on income level
• Taxation of Capital Losses
– Capital losses can be used to offset capital gains
– Up to $3,000 per year of capital losses can be used to offset
ordinary income (such as wages)
1-15
Tax-Advantaged Retirement Vehicles
• Allows taxes to be deferred until withdrawn
in future
• Employer-sponsored plans
– Profit-sharing plans, thrift and savings plans,
and 401(k) plans
• Self-employed individual plans
– Keogh plans and SEP-IRAs
• Individual plans
– Individual retirement arrangements (IRAs) and Roth IRAs
1-16
Retirement Accounts:
Company Sponsored Plans, I.
•
You will probably have access to a company-sponsored retirement plan
such as a 401(k).
• In a typical plan, you (the employee) decides how much money to
contribute to the plan through payroll deductions.
• Generally, your employer also makes contributions to the plan.
– For example, your company could make dollar-for-dollar
matching contributions up to a certain percentage of your salary.
– Even after your contributions hit the maximum amount your
employer will match, you can still contribute additional funds.
– The amount of your total contribution is limited by the Internal
Revenue Service (IRS).
2-17
Retirement Accounts:
Company Sponsored Plans, II.
•
The general investing approach applies to your retirement plan.
– You decide your percentage allocations to asset classes (like stocks, bonds,
and T-bills) and then choose particular securities (i.e., mutual funds) in each
asset class.
– You will also make the decision whether to invest in U.S. securities,
securities in other regions of the world, securities in specific countries, large
company securities, small company securities, or a combination of these
categories.
•
The primary benefit of company-sponsored plans is that money
you deposit into the account lowers your taxable income.
– So, your tax bill is lower, and your net “out of pocket” cost is lower.
– For example, if you are in the 25 percent tax bracket and decide to deposit
$12,000 next year, your net out of pocket cost is only $9,000.
– Why? You will pay $3,000 (.25*$12,000) less in taxes than you would if you
had not made this deposit.
•
Of course, nothing is free. You must pay taxes on the withdrawals
you make during retirement.
2-18
Individual Retirement Accounts, IRAs
• Generally, IRAs are for people who do not have access to a
company-sponsored plan.
• The essential difference between IRAs lies in taxes (“Pay me now, or
pay me later.”)
– Roth Individual Retirement Account (Roth IRA)
• Today, you invest after-tax money.
• Therefore, you pay no taxes when you make withdrawals.
• So, capital gains and dividends accumulate tax-free.
– “Tax-Deferred” or Traditional IRAs
• You do not pay taxes on money you place into this account.
• When money is removed from this account, you pay taxes.
• Roth IRAs benefit younger investors in a low tax bracket.
2-19
BUYING AND SELLING
SECURITIES
2-20
Buying and Selling Securities
• This chapter covers the basics of the investing process.
• We begin by describing how you go about buying and
selling securities, such as stocks and bonds.
• Then, we outline some important considerations and
constraints to keep in mind as you get more involved in
the investing process.
2-21
Getting Started
(a) Open a brokerage
or trading account
(b) Deposit $10,000
into account
(d) Pay Commission,
Say $50
(c) Buy 100 Shares
of Disney
at $33 per share
(e) $6,650 Cash
in Account
$3,300 Stock
In Account
2-22
Choosing a Broker, I.
•
Brokers are now divided into three groups:
1. Full-service brokers
2. Discount brokers
3. Deep-discount brokers
•
These three groups can be distinguished by the level of service
provided, as well as the level of commissions charged.
2-23
Major Full-Service, Premium Discount, and Basic Discount
Brokers
2-24
Choosing a Broker, II.
• As the brokerage industry becomes more competitive, the
differences among broker types continues to blur.
• Another important change is the rapid growth of online brokers, also
known as e-brokers or cyberbrokers.
• Online investing has really changed the brokerage industry.
– slashing brokerage commissions
– providing investment information
– Customers place buy and sell orders over the Internet
2-25
Securities Investor Protection Corporation
• Securities Investor Protection Corporation (SIPC): Insurance
fund covering investors’ brokerage accounts when member firms go
bankrupt or experience financial difficulties.
• Most brokerage firms belong to the SIPC, which insures each
account for up to $500,000 in cash and securities, with a $100,000
cash maximum.
• Important: The SIPC does not guarantee the value of any
security (unlike FDIC coverage).
• Rather, SIPC protects whatever amount of cash and securities
that were in your account, in the event of fraud or other failure.
2-26
Broker-Customer Relations
• There are several important things to remember when you deal with
a broker:
•
–
Any advice you receive is not guaranteed.
–
Your broker works as your agent and has a legal duty to act in your best
interest.
–
However, brokerage firms make profits from brokerage commissions.
Your account agreement will probably specify that any disputes will
be settled by arbitration and that the arbitration is final and binding.
2-27
CASH VS. MARGIN TRADING
2-28
Brokerage Accounts
• A Cash account is a brokerage account in which securities are paid
for in full.
• A Margin account is a brokerage account in which, subject to limits,
securities can be bought and sold short on credit.
(more on selling short later)
2-29
Margin Accounts
•
In a margin purchase, the portion of the value of an investment that is
not borrowed is called the margin.
𝑌𝑜𝑢𝑟 𝑀𝑜𝑛𝑒𝑦
𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
Where
“Your Money”
= Value of Securities minus Margin Loan
•
Of course, the portion that is borrowed incurs an interest charge.
– This interest is based on the broker’s call money rate.
– The call money rate is the rate brokers pay to borrow money to lend to
customers in their margin accounts.
2-30
Practices
•
Example 1: Margin requirement = 80%.
– This means that your money represents at least 80% of the total dollars you
spend to buy stocks.
– Suppose KO is traded at $40 per share AND you have only $40,000.
– Without margin, you can buy only 1,000 shares (=$40,000/$40 per share).
– With margin, you can spend up $50,000 ($40,000/80%) or 1,250 shares
(=$50,000/$40 per share). Margin loan is $10,000.
– If KO rises to $50 per share,
• new margin = (62,500- 10,000)/62,500=84%
– If KO falls to $30 per share,
• new margin = (37,500- 10,000)/37,500=73.33%
•
Example 2: Margin requirement = 50%.
– This means that your money represents at least 50% of the total dollars you
spend to buy stocks.
– Suppose KO is traded at $40 per share AND you have only $40,000.
– Without margin, you can buy only 1,000 shares (=$40,000/$40 per share).
– With margin, you can spend up $80,000 ($40,000/50%) or 2,000 shares. Margin
loan is $40,000.
– If KO rises to $50 per share,
• new margin = (100,000- 40,000)/100,000=60%
– If KO falls to $30 per share,
• new margin = (60,000- 40,000)/60,000=33.33%
2-31
Example: Margin Accounts,
The Balance Sheet
• You buy 1,000 Pfizer shares at $24 per share.
• You put up $18,000 and borrow the rest.
• Amount borrowed = $24,000 – $18,000 = $6,000
• Margin = $18,000 / $24,000 = 75%
Liabilities and
Account Equity
Assets
1,000 Shares, PFE
Total
$ 24,000
$ 24,000
Margin Loan
$ 6,000
Account Equity
$ 18,000
Total
$ 24,000
2-32
Simulation Analysis
Example: Buying 1,000 shares of stock at $24 with a
margin loan of $6,000
Stock
Price
Value of
Margin
Securities Loan
Equity
(“Your Money”)
Margin
$24
$24,000
$6,000
$18,000
(=24,000-6,000)
75%
(=18,000/24,000)
$30
30,000
6,000
24,000
80%
$20
20,000
6,000
14,000
70%
$10
10,000
6,000
4,000
40%
If the brokerage firm requires your account to maintain 50% margin and
currently the stock price is $10 per share, you need to deposit additional
$1,000 into an account.
Detail: 50% = X / 10,000, X=5,000. This means that you must maintain at
least $5,000 equity in your account, but currently your equity is only $4,000.
2-33
Margin Accounts
• In a margin purchase, the minimum margin that must be supplied is
called the initial margin.
– Initial margin is set by the Fed, usually 50%.
• The maintenance margin is the margin amount that must be
present at all times in a margin account.
– Set by the brokerage or the exchange
• When the margin drops below the maintenance margin, the
broker can demand more funds. This is known as a margin call.
• When the margin call is provoked, an investor must bring the margin
back to the initial margin.
2-34
Example: The Workings of
a Margin Account, I
• Your margin account requires:
• an initial margin of 50%, and
• a maintenance margin of 30%
• A Share in Miller Moore Equine Enterprises (WHOA) is selling for $50.
• You have $20,000, and you want to buy as much WHOA as you can.
• You may buy up to $20,000 / 0.5 = $40,000 worth of WHOA.
Liabilities and
Account Equity
Assets
800 Shares of WHOA
@ $50/share
Total
$ 40,000
$ 40,000
Margin Loan
$ 20,000
Account Equity
$ 20,000
Total
$ 40,000
2-35
Example: The Workings of
a Margin Account, II
•
After your purchase, shares of WHOA fall to $35. (Woe!)
•
New margin = $8,000 / $28,000 = 28.6% < 30%
•
Therefore, you are subject to a margin call.
•
You must deposit $6,000 ( = 50% of $28,000 - $8,000)
Liabilities and
Account Equity
Assets
800 Shares of WHOA
@ $35/share
Total
$ 28,000
$ 28,000
Margin Loan
$ 20,000
Account Equity
$ 8,000
Total
$ 28,000
2-36
Example: How Low Can it Go?
•
At what price will you receive a margin call?
Number of Shares  P   Amount Borrowed
Maintenance Margin Level 
*
Number of Shares  P*
Solving for the critical stock price, P* , results in
P 
Amount Borrowed
Number of Shares
1 - Maintenance Margin Level
*
So here,
$20,000
P* 
800  25  $35.71.
1 - 0.30
0.70
P
50
40
36
35
V of
stock
40000
32000
28800
28000
Your
money
20000
12000
8800
8000
margin
50.0%
37.5%
30.6%
28.6%
Margin Call
no call
no call
no call
margin call
2-37
Example: The Effects of Margin, I.
•
•
•
•
•
You have $30,000 in a margin account, 60% initial margin required.
You can buy $50,000 of stock with this account (why?).
Your borrowing rate from your broker is 6.00%.
Suppose you buy 1,000 shares of Coca-Cola (KO), for $50/share.
Assume no dividends, and that your borrowing rate is still 6.00%,
what is your return if:
– In one year, KO is selling for $60 per share?
– In one year, KO stock is selling for $60 per share, but you did not
borrow money from your broker? +20%
2-38
Example: The Effects of Margin, II.
• KO is selling for $60 per share.
• Your investment is worth $60,000.
• You owe 6% on the $20,000 you borrowed: $1,200.
• If you pay off the loan with interest, your account balance is:
$60,000 – $21,200 = $38,800.
• You started with $30,000.
• Therefore, your return is $8,800 / $30,000 = 29.33%.
• Suppose Coca-Cola stock was selling for $40 per share instead
of $60 per share? What is your return?
2-39
Example: The Effects of Margin, III.
• Coca-Cola stock is selling for $60 per share, but you did not
borrow from your broker.
• You started with $30,000, which means you were able to buy
$30,000 / $50 = 600 shares.
• Your investment is now worth $36,000.
• Therefore, your return is $6,000 / $30,000 = 20.00%.
• Suppose Coca-Cola is selling for $40 per share instead of $60
per share. What is your return in this case? -20%
2-40
Example: Annualizing Returns
on a Margin Purchase, I.
• You buy 1,000 shares of Costco (COST) at $60 per share.
• Your initial margin is 50%.
• You borrow at the 9 percent call money rate plus 2 percent.
• You sell Costco (COST) 3 months later for $63.
• There were no dividends paid (and suppose the prices above are net
of commissions).
• What is your holding period percentage return and your EAR?
2-41
Annualizing Returns on a Margin Purchase, II.
Answer: First, you have to repay the 3-month loan, so: t = (3/12 = .25)
Amount Repaid = Amount Borrowed × (1 + interest rate per year)t
Amount Repaid = $30,000 × (1 + .11).25
= $30,000 × 1.02643
= $30,792.90
Your Sale Proceeds = Cash from Sale – Amount Repaid
= $63,000 – 30,792.90
= $32,207.10
Your Profit = Your Sale Proceeds – Your Investment
= $32,207.10 - $30,000
= $2,207.10
2-42
Annualizing Returns on a Margin Purchase, III.
Holding Period Percentage Return 
$32,207.10 - $30,000 $2,207.10

 0.0736
$30,000
$30,000
1  EAR  (1  Holding Period Percentage Return) m
 (1  0.0736) 4
 1.3285
So your EAR is about 32.85%.
Note that there are 12/3 = 4
three-month holding periods in
a year. Therefore, m = 4.
2-43
Hypothecation and Street Name Registration
• Hypothecation is the act of pledging securities as a collateral
against a loan.
• This pledge is needed so that the securities can be sold by the
broker if the customer is unwilling or unable to meet a margin call.
• Street name registration is an arrangement under which a broker is
the registered owner of a security. (You, as the account holder are
the “beneficial owner.”)
2-44
Other Account Issues, I.
• Trading accounts can also be differentiated by the ways
they are managed.
– Advisory account - You pay someone else to make buy and sell
decisions on your behalf.
– Wrap account - All the expenses associated with your account
are “wrapped” into a single fee.
– Discretionary account - You authorize your broker to trade for
you.
– Asset management account - Provide for complete money
management, including check-writing privileges, credit cards, and
margin loans.
2-45
Other Account Issues, II.
• To invest in financial securities, you do not need an
account with a broker.
• One alternative is to buy securities directly from the
issuer.
• Another alternative is to invest in mutual funds
– Mutual funds: Combining or pooling the funds of a large group of
investors.
2-46
SHORT SELLING STOCKS
2-47
Short Sales
• An investor with a long position benefits from price increases.
– Easy to understand
– You buy today at $34, and sell later at $57, you profit!
– Buy low, sell high
– “Go long” means you buy.
• An investor with a short position benefits from price decreases.
– Also easy to understand
– You sell today at $83, and buy later at $27, you profit.
– Sell high, buy low
– “Go short” means you sell.
2-48
Short Sales
• Short Sale is a sale in which the seller does not actually
own the security that is sold.
Borrow
shares
from
someone
Sell the
Shares
in the
market
Today
Buy
shares
From the
market
Return
the
shares
In the Future
Note that an investor who buys and owns shares of stock is said to be
“long the stock” or to have a “long position.”
2-49
Short Sales
• Short sale requirements
– There is an initial margin and a maintenance margin
– After you sell the borrowed stock, the proceeds from the sale are
credited to your account.
– But, you cannot use them until you “cover” the short position.
– If any dividends are paid on the stock while you have a short
position, you must repay them.
– The owner of the shares need NOT know that the shares have
been lent to the short-seller.
– If the owner wishes to sell the shares, the brokerage firm will
simply borrow shares from another investor.
2-50
Short Sales
• Four items on the account balance sheet
–
–
–
–
Proceeds from sale
Margin deposit
Short position
Account equity
2-51
Example: Short Sales, I.
•
You short 100 shares of Texas Instruments (TXN) at $30 per share.
•
Your broker has a 50% initial margin and a 40% maintenance margin on
short sales.
•
The value of stock borrowed that will be sold short is:
$30 × $100 = $3,000
Liabilities and
Account Equity
Assets
Sale Proceeds
$ 3,000
Short Position
$ 3,000
Initial Margin Deposit
$ 1,500
Account Equity
$ 1,500
Total
$ 4,500
Total
$ 4,500
2-52
Example: Short Sales, II.
• Texas Instrument stock price falls to $20 per share.
• Sold at $30, value today is $20, so you are "ahead" by $10 per
share, or $1,000.
• Also, new margin: $2,500 / $2,000 = 125%
Liabilities and
Account Equity
Assets
Sale Proceeds
$ 3,000
Short Position
$ 2,000
Initial Margin Deposit
$ 1,500
Account Equity
$ 2,500
$ 4,500
Total
$ 4,500
Total
2-53
Example: Short Sales, III.
• Texas Instruments stock price rises to $40 per share.
• You sold short at $30, stock price is now $40, you are
"behind" by $10 per share, or $1,000. (He who sells what isn’t
his’n, must buy it back—or go to prison.)
• Also: new margin = $500 / $4,000 = 12.5% < 40% Therefore,
you are subject to a margin call.
Assets
Liabilities and
Account Equity
Sale Proceeds
$ 3,000
Short Position
$ 4,000
Initial Margin Deposit
$ 1,500
Account Equity
$
Total
$ 4,500
Total
$ 4,500
500
2-54
2-55
2-56
Finding P*
2-57
More on Short Sales
• Short interest is the amount of common stock held in short
positions.
• In practice, short selling is quite common and a substantial volume of
stock sales are initiated by short sellers.
• Note that with a short position, you may lose more than your total
investment, as there is no theoretical limit to how high the stock price
may rise.
2-58
Biggest Short Positions
(from The Wall Street Journal)
2-59
Short Selling Report from The Wall Street Journal
2-60
Finding Actual Short Positions
(from finance.yahoo.com)
2-61
Useful Internet Sites
•
•
•
•
•
•
•
•
•
www.finra.org (a reference for dispute resolution)
www.bearmarketcentral.com (a reference for short selling)
www.nasdaq.com (a reference for short interest)
www.moneycentral.msn.com (a reference for building a portfolio—search
the site for “Build your first stock portfolio”)
www.sharebuilder.com (a reference for opening a brokerage account)
www.buyandhold.com (another reference for opening a brokerage account)
www.individual.ml.com (a risk tolerance questionnaire from Merrill Lynch)
www.money-rates.com (a reference for current broker call money rate)
finance.yahoo.com (a reference for short sales on particular stocks)
2-62
Chapter Review
•
Getting Started
–
–
–
–
•
Brokerage Accounts
–
–
–
–
–
•
Choosing a Broker
Online Brokers
Security Investors Protection Corporation
Broker-Customer Relations
Cash Accounts
Margin Accounts
A Note on Annualizing Returns
Hypothecation and Street Name Registration
Other Account Issues
Short Sales
– Basics of a Short Sale
– Some Details
•
Investor Objectives, Constraints, and Strategies
– Risk and Return
– Investor Constraints
– Strategies and Policies
2-63
• Cash held in a brokerage account is insured up to
$100,000 by the FDIC.
A) True
B) False
2-64
• Hypothecation is the pledging of securities as collateral
for a loan.
A) True
B) False
2-65
• You short sold $5,000 worth of stock. Your maximum loss
is $5,000.
A) True
B) False
2-66
• Online brokers:
A) became popular in the mid-1980's.
B) have effectively lowered the cost of trading.
C) place orders on your behalf.
D) face minimal competition.
E) never offer check-writing privileges or debit cards.
2-67
• You open a brokerage account with $10,000 in cash.
Subsequently, you purchase 1,000 shares of a stock at
$16 a share on margin. Which one of the following
account values is correct concerning your account
position after the stock purchase?
A) margin loan of $10,000
B) total assets of $26,000
C) account equity of $10,000
D) total assets of $10,000
E) account equity of $6,000
2-68
• The maximum maintenance margin that your broker
might require on stock purchases is _____ percent.
A) 60
B) 70
C) 80
D) 90
E) 100
2-69
• You own 300 shares of stock which dropped drastically in
value today down to $13.50 a share. You have a margin
loan of $2,880. What is the amount of your margin call if
the maintenance margin is 40 percent?
A) $0
B) $450
C) $950
D) $1,260
E) $3,150
2-70
• Jonathan owned a bond for 3 months and realized a
holding period return of 4.5 percent. Hallie owned a
similar bond for 4 months and had a holding period return
of 4.5 percent. Jonathan earned an effective annual rate
of _____ percent and Hallie earned an effective annual
rate of _____ percent.
A) 16.50; 12.25
B) 17.56; 13.13
C) 18.00; 13.50
D) 18.67; 13.87
E) 19.25; 14.12
2-71