Chapter Three
McGraw-Hill/Irwin
PARTICIPATING IN
THE MARKET
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© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Measures of Price Performance:
Market Indexes
Indexes and Averages

Dow Jones Averages

Standard & Poor Indexes

Value Line Average

Other Market Indexes
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

Cash or Margin Account
Long or Short?
–That Is The Question

Capital Gains and Dividends
3

MEASURES OF PRICE PERFORMANCE
COMPARE WITH MARKET INDEXES
Please click on the icon for more information on the indexes
TYPE OF PORTFOLIO
Professional pension fund manager’s portfolio
Mutual fund specializing in small OTC stocks
Portfolio of a small investor
(in small cap stocks)
RELEVANT INDEX
S&P 500 Stock Index www.standardandpoors.com
Nasdaq www.nasdaq.com
Value Line Average or
Russell 2000 www.russell.com
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
Statistical indicator providing a representation of the value of the securities which constitute it. Indexes often serve as barometers for a given market or industry and benchmarks against which financial or economic performance is measured.
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



Dow Jones Averages
• www.dj.com
Standard & Poor’s Indexes
• www.standardpoors.com
Value Line Average
• www.valueline.com
Other Market Indexes
• www.nasdaq.com

National Association of Securities
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


Industrial (DJIA)
Transportation (DJTA)
Utilities (DJUA)
Averages are maintained and reviewed by editors of The Wall Street Journal . For the sake of continuity, composition changes are rare, and generally occur only after corporate acquisitions or other dramatic shifts in a component's core business. When such an event necessitates that one component be replaced, the entire index is reviewed. As a result, multiple component changes are often implemented simultaneously
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continued

There are no rules for component selection, a stock typically is added only if it has
• an excellent reputation
• demonstrates sustained growth
• is of interest to a large number of investors
• accurately represents the sector(s) covered by the average
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


DJTA include only transportation stocks
DJUA include only utilities stocks
DJIA not limited to traditionally defined industrial stocks
• Serves as a measure of the entire U.S. market, covering such diverse industries as
 financial services
 technology
 retail
 entertainment
 consumer goods 9

Calculation of DJIA






Unique
• price weighted
• NOT market capitalization weighted
Component weightings affected only by changes in the stocks' prices
NOT (in contrast with other indexes‘) weightings that are affected by both price changes and changes in the number of shares outstanding
Initially, their values were calculated by simply adding up the component stocks' prices and dividing by the number of components
Later, adjusting the divisor was initiated to smooth out the effects of stock splits and other corporate actions
The current divisor values are as follows: DJIA
0.13561241, DJTA 0.22477839, and DJUA 1.5940823
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DOW JONES INDUSTRIAL
AVERAGE - DJIA

The most popular index


30 large industrial companies
“blue-chip” index i.e. stocks of very high quality

Price-weighted average

Follow the general trend of the market

Comprise more than 25% of market value of the
3,000 firms listed on the NYSE

Bias toward high priced stocks www.djindexes.com
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
S&P 500 – a measure of broad stock market activity (about 75% of the total value of the 3,000 firms listed on the
NYSE

Used by:
• professional money managers
• Security market researchers
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
Composed of
• 400 middle-sized firms

Firms with market values between
$1.2 billion and $9 billion versus S&P
500 which shows the performance of large firms like Microsoft – stock symbol MSFT, market value $300 billion in January 2004
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


S&P 600 SmallCap Index
• Companies smaller that MidCap
S&P 1500 combines
• S&P 500
• S&P 600 &
• S&P 400
S&P 100
• 100 blue-chip stocks

For which CBOE has individual option contracts
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The Complete List
100 Stocks in NAZDAQ-100
Please click on the following Hyperlink for the complete list
NASDAQ-100 (the index itself)

The Index reflects Nasdaq's largest growth companies across major industry groups. All index components have a minimum market capitalization of $500 million, and an average daily trading volume of at least 100,000 shares
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
The Nasdaq 100 Index Tracking Stock
(symbol) QQQQ is an Exchange Traded
Fund which allows investors to essentially invest in all of the stocks that make up the Nasdaq 100 in a single security
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This graph shows how closely the shadow QQQ follows the Nasdaq
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
Standard & Poor’s Indexes
• value-weighted indexes
 each company weighted by its total market value as a percentage of the total market value for all firms
Example – a value-weighted index comprising of three firms A, B, and C the weighting is shown on the next slide
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Application Example
Value-weighted Indexes
Stock Shares Price Total Market Value Weighting
A 150 $10 $1,500 12.0%
B
C
200
500
$20
$14
$4,000
$7,000
$12,500
32.0%
56.0%
100.0%
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Value Line Average

1,700 companies from NYSE, AMEX, and
NASDAQ

Equal-weighted index
• Weighted equally
• Regardless of market price or total market value

Equal-weighting more closely conforms to the portfolio of individual investors
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New York Stock Exchange http://money.cnn.com/mark ets/nyse/
The American Stock
Exchange http://www.amex.com/
Wilshire 5000 Equity Index http://www.neatideas.com/ w5000.htm
Russell 3000 Index symbol: $RAZ.X
Russell 2000
Russell 1000 http://www.neatideas.com/r
2000.htm
Index symbol:
$RUXY or $RUI.X
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Every major country has an index that represents its stock exchange. Here are some of the more important indexes around the world:






FTSE 100 - United Kingdom
Hang Seng - Hong Kong
Nikkei - Japan
DAX – Germany (Frankfurt DAX )
TSX - Canada
CAC 40 France
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Important Consideration of looking at an INDEX

How much the index has changed over a given period of time
• Hours (intraday)
• Day
• Week
• Month
• Quarter
• Semi-annual
• Year(s)
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
Not widely followed by
• Index or
• Average

Gauged by
• Interest-rate movements
Rising interest rates falling bond prices
Falling interest rates rising bond prices
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Other Categories of Bonds





Treasury Securities
• Treasury notes
• Treasury Bills
• Treasury Bonds
Corporate debt
Mortgaged-backed securities
Municipal Bonds
Eurobonds
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
Mutual funds
• Preferred choice of investment for many investors in the U.S. & worldwide

Commitment to mutual funds
• Necessity of understanding the underlying

Stocks

Bonds
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


Using full service brokers, e.g.
• Merrill Lynch
• Salmon Smith Barney
• UBS Paine Webber
Broker must determine investors’ objective
• Conservative – preservation of capital
• Income
• Growth plus income
• Growth
Risk versus (expected) return
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Buying and Selling in the Market continued

Using discount brokers

Using online brokers
• Charge very low commissions
• Give stripped-down service
• No investment advice
• Communications usually by emails
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
Cash account Full payment

Margin account Pay a percentage

Settlement in three (3) business days for both type of account

Margin percentage set by the Federal
Reserve Bank
• Used to control speculation
• 10% in 1920s
• 80% in 1968
• 50% since 1974
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ACTION
Long or Short? –
That is the Question
OBJECTIVE POSITION
Buy stocks
Profit from expected increase in price
Long
Sell stocks
(not owned)
Profit from expected decline in price
Short
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
Market order – usually trade close to the last price

Limit orders
• When buying – pay NO more than the limit price
• When selling – receive no less than the limit price

Stop order - an order to buy or sell a stock once the price of the stock reaches a specified price, known as the stop price.
When the specified price is reached, the stop order becomes a market order
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Length of Time for Executing
Orders to Buy/Sell Securities

Day orders – expire at the end of the day

Good till canceled (GTC) - order to buy or sell a security that is good until the investor decides to cancel it
• Most brokerage firms let GTC orders automatically expire after 30 - 60 days
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
Full-service brokerage
• Merrill Lynch
• UBS PaineWebber
• Morgan Stanley Dean Witter

Discount brokers
• Charles Schwab
• Quick &Reilly
• Olde

Online brokers
• Ameritrade
• E-trade 33

Effects of Pricing Differential
Example: 100 shares traded at
$40/share i.e. total of $4,000
Broker type Commission/Total trade
% commission
Online $15/$4,000 0.37
Discount
Full-service
$42/$4,000
$100/$4,000
1.05
2.50
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Other Factors to Consider before
Choosing the Type of Brokerage Service

Degree of sophistication of the investor

Degree of complexity of the investment
• Capital gains tax implications
• Potential merger offers
• Retirement planning
• Estate planning

ALL the above may outweigh savings in commissions
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The Merits and Drawbacks of
Internet & Online Trading
Pros
Availability of instant information
Cons
How to interpret the information
Downloading

Balance sheets

Income statement
The requirement to know

Accounting

Finance
 releases

Economics
(Hint: Google search for Free
Edgar, requires free registrartion)

Tax

Legal issues
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
Legal tax advice provided only by a CPA or
CFP (Certified Financial Planner)

Tax considerations could outweigh savings on brokerage commissions
Please click on the following icon for a summary of the 2003 Tax Act www.turbotax.com
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Calculating the Marginal Tax Rates
Example: Single - taxable income of $34,000
Amount
First $7,000
Rate in % Tax in $
10% $700
Next $21,400*
Next $5,600**
15%
25%
$3,210
$1,400
$5,310
* $28,400 – $7,000
** $34,00 - $28,400
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Calculating the Average Tax
Example: Single - taxable income of $34,000

Amount of taxes paid

Divided by taxable income
Taxes paid $5,310.10
=
Taxable income $34,000.00
Average Tax Rate = 15.62%
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
Capital gain or loss
• Asset held for investment purposes
• Sold
Asset held for more than one year
Long-term capital gain
Max tax rate on dividends 15%
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Comparing Taxes
Long-term Capital Gains versus
Short-term Capital Gains
Holding Period Profit Tax Rate Taxes
6 months $10,000 35% $3,500
Over 12 months $10,000 15% $1,500
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Website www.msci.com
www.barra.com
www.sec.gov
www.quicken.com
finance.yahoo.com/
Comment
Provides information on bond and stock indexes
Provides information on various modified indexes
Provides access to SEC filings
Provides access to company SEC filings
Profile pages on stock quotes provide access to
42 company SEC filings

Website Comment www.standardandpoors.com
www.dowjones.com
www.ashkon.com/nasdaq-100.html
http://www.investorwords.com
http://finance.yahoo.com/etf/education/04 http://finance.yahoo.com/q?s=QQQQ www.sec.gov
www.bloomberg.com
Contains information about S&P indexes and the markets
Provides information about the
Dow Jones indexes
Components of NASDAQ-100
(QQQ)
Investing glossary
Exchange Traded Funds
Quotes and Information
US Security and Exchange
Commission’s website
Market data: rates & bonds
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