Investing What do you know about investing? Has anyone here ever made an investment? How many of you follow the stock market, or read the business section of the paper? What’s a prospectus? What is selling short and why do some people HATE it? How does the stock market relate to the economy as a whole? Why do we have a stock market? Think about this statement: “Saving money makes economic growth and investment possible, since one man’s savings is another man’s loan.” Financial Markets: Basic Tenets Financial systems consist of financial institutions/ intermediaries that transfer savings to investors Banks, Savings and Loan Associations, & Credit Unions take in deposits from savers and then lend some of these funds to various businesses. Banks don’t just keep your money under a rock in the vault!!!!! When savers invest, they receive documents confirming their deposit or bond purchase, such as passbooks or bond certificates. These documents are known as financial assets. They represent claims on property or income of the borrower. Governments and businesses are the largest borrowers. Financial assets include savings accounts, certificates of deposit, and either corporate or government bonds Non-bank Financial Intermediaries Finance Companies--Make loans to consumers and small businesses, but charge borrowers higher fees and interest rates to cover possible losses. They buy installment contracts from merchants who sell goods on credit. Many offer loan consolidation. Mutual Funds--Pool the savings of many individuals and invest this money in a variety of stocks and bonds. Gives “common folk” a chance to invest in the market at lower risk (?) Life Insurance Companies--Provide financial protection to the family or other beneficiaries of the insured. Companies invest premiums until death benefits must be paid out. Some build cash value—can be “cashed in.” Pension Funds---Are set up by employers to collect deposits and distribute payments to retirees. They receive money from employers/employees (some nice employers offer matching contributions) and invest in corporate stocks and bonds. EX: 401 (k)—key advantage: TAX DEFERRED! AKA IRA’s (Individual Retirement Accounts. Roth IRAs are financially attractive— contributions are made after taxes, so none are taken out at maturity Real Estate Investment Trusts (REIT)—borrow money from banks & loan it to construction companies who build homes The Flow of Savings and Investments Services Provided by Financial Intermediaries Sharing Risk--Diversification is the spreading out of investments to reduce risk. Financial intermediaries help individual savers diversify their investments. Providing Information--Financial intermediaries reduce the costs in time and money that lenders and borrowers would pay if they had to search out investment information on their own. Providing Liquidity--Financial intermediaries allow savers to easily convert their assets into cash. Private Enterprise and Investing Investment is the act of redirecting resources from being consumed today so that they may create benefits in the future. In short, investment is the use of assets to earn income or profit. When people save or invest their money, their funds become available for businesses to use to expand and grow. In this way, investment promotes economic growth. Risk and Return • Return is the money an investor receives above and beyond the sum of money initially invested (principal) • Savings accounts are very liquid, but in general have a lower rate of return. Statement savings slightly higher. Certificates of deposit usually have a greater return but liquidity is reduced. Usually penalties for early withdrawal. Stocks vary—remember that holding stocks can lead to a loss of principal. Enron situation is typical. In general, the higher potential return of the investment, the greater the risk involved. • EX: Investing in a friend’s Internet company could make you filthy rich, but there is risk of company failure • EX2: “Blue chip” stocks offer medium returns, but as established companies, it’s pretty difficult for you to lose money. Well, it WAS pretty difficult. Investment Review: Section 1 1. Investment is (a) providing money for your family. (b) the act of redirecting resources from being consumed today so that they may create benefits in the future. (c) an institution that helps channel funds from savers to borrowers. (d) a collection of financial intermediaries. 2. The money an investor receives above and beyond the money initially invested is called (a) investment. (b) savings. (c) return. (d) prospectus. Basic Investment Considerations The type of investment chosen should depend on the goals of the investor and your willingness to accept RISK! Short-term: low risk or (virtually) no risk: (CAN’T lose principal). Stick with savings accounts, short-term CDs, money market funds Intermediate: low to moderate risk, largely determined by investor. High-grade corporate bonds and stocks Long-range: growth funds, moderate risk Key to any successful plan: DIVERSIFICATION. Some stocks, some bonds, some liquid assets Bonds as an Investment Vehicle Bond: a long-term obligation by the government or a corporation to pay a fixed amount of interest every year until maturity. Bonds have 3 components: The coupon rate--the interest rate that the bond issuer will pay to the bondholder. The maturity-- the time at which payment to the bondholder is due. Par Value--the amount that an investor pays to purchase the bond and that will be repaid to the investor at maturity. Par value is also called face value or principal. Bond Prices are determined by supply and demand Current yield= (Annual int. rate)/(purchase price) Bonds CAN be called early Bond Value—an Example Suppose you have a $10,000 bond earning 7% interest, or $700/year. The face value is $10,000 and is payable at maturity. If interest rate went to 10%, that bond is underperforming. So you sell it. But you won’t get $10,000. It’s only worth $7000. So you bargain and probably get $8500 for it. Bond Ratings Standard & Poor’s and Moody’s rate bonds on a number of factors, including the issuer’s ability to make future payments and to repay the principal when the bond matures. A high bond rating usually means that the bond will sell at a higher price, and that the firm will be able to issue the bond at a lower interest rate. Standard & Poor’s Highest investment grade High grade Upper medium grade Medium grade Lower medium grade Speculative Vulnerable to default Subordinated to other debt rated CCC Subordinated to CC debt Bond in default Moody’s AAA AA A BBB BB B CCC CC C D Best quality High quality Upper medium grade Medium grade Possesses speculative elements Generally not desirable Poor, possibly in default Highly speculative, often in default Income bonds not paying income Interest and principal payments in default Aaa Aa A Baa Ba B Caa Ca C D Types of Bonds Savings Bonds-- are low-denomination ($50 to $10,000), non-transferable bonds issued by the United States government. Savings bonds are purchased below par value (a $100 savings bond costs $50 to buy) and interest is paid only when the bond matures. Treasury Bonds, Bills, and Notes--These investments are issued by the United States Treasury Department. Municipal Bonds--are issued by state or local governments to finance such improvements as highways, state buildings, libraries, and schools. Federally tax-exempt in most cases Corporate Bonds-- are bonds that a corporation issues to raise money to expand its business. Junk Bonds--are lower-rated, potentially higher-paying bonds. EX: Comcel, cellular telephone company in Bogota. “T-eed off” Treasury Bill (T-Bill): Short-term bill used to finance federal government borrowing (13, 26, or 52 weeks). Sold on a discount basis. Treasury Notes—2-10 year bonds Treasury Bonds—10 to 30 years. Notes and bonds for 2-3 years are $5000 denominations, longer than 4 years $1000. Periodic interest is paid by the government via a computer network Collateral: faith in the US government, ability to raise taxes, etc. Low return, very low risk Advantages/Disadvantages of Bonds to Bond ISSUERS Advantages: 1. Once the bond is sold, the coupon rate for that bond will not go up or down. 2. Unlike stock, bonds are not shares of ownership in a company. Disadvantages: 1. The company must make fixed interest payments, even in bad years when it does not make money. 2. If the issuer does not maintain financial health, its bonds may be downgraded to a lower bond rating. This makes it harder to sell future bonds unless a discount or higher interest rate is offered. Other Types of Financial Assets Certificates of Deposit Money Market Mutual Funds Money market mutual funds are special types of mutual funds. Certificates of deposit (CDs) are available through banks, which use the funds deposited Investors receive higher interest on a money market in CDs for a fixed mutual fund than they amount of time. would receive from a CDs have various terms savings account or a CD. of maturity, allowing However, assets in money investors to plan for market mutual funds are future financial needs. not FDIC insured. No risk, low return. Financial Asset Markets One way to classify financial asset markets is according to the length of time for which the funds are lent. Capital markets are markets in which money is lent for periods longer than a year. CDs and corporate bonds are traded in capital markets. Money markets are markets in which money is lent for periods of less than a year. Short-term CDs and Treasury bills are traded in money markets. Markets can also be classified according to whether assets can be resold to other buyers. Primary markets involve financial assets that cannot be transferred from the original holder, such as savings bonds. Secondary markets involve financial assets that can be resold, such as stocks, bonds, and treasury bonds and notes (but not bills!). See figure 12-6 in text. Section Review—Risk and Bonds 1. A bond is a (a) loan that represents debt that the government or a corporation must repay to an investor. (b) portion of ownership in a corporation. (c) system that allows the transfer of funds between savers and borrowers. (d) collection of financial assets. 2. How does the risk involved in a money market mutual fund compare with the risk of a certificate of deposit? (a) The risk of the money market mutual fund is less than the certificate of deposit. (b) The risk of the money market mutual fund is slightly greater than the certificate of deposit. (c) The risk of the money market mutual fund is much greater than the certificate of deposit. (d) The risk of both is about the same. Purchasing Stock Corporations can raise money by issuing stock, which represents ownership in the corporation. A portion of stock is called a share. Stocks are also called equities. Stockowners can earn a profit in two ways: 1. Dividends, which are portions of a corporation’s profits, are paid out to stockholders of many corporations. The higher the corporate profit, the higher the dividend. 2. A capital gain is earned when a stockholder sells stock for more than he or she paid for it. A stockholder that sells stock at a lower price than the purchase price suffers a capital loss. Stock Market Efficiency Efficient Market Hypothesis: It is not possible to “beat the market” regularly. This explains the plight of daytraders. Daytraders use computer programs to try and predict minute-byminute price changes in hopes of earning a profit. Consistent investing over the long-term, however, can create large gains Instead of trying to beat the market, investors should diversify their portfolio to scatter risk. Most CFP’s recommend a combination of stocks, bonds, and highliquidity investments. Also scatter your risk by having some higher risk stocks and some lower risk stocks. Types of Stock Dividend Differences Income stock pays dividends at regular times during the year. Growth stock pays few or no dividends. Instead, the issuing company reinvests earnings into its business Decision-Making Differences Investors who buy common stock are voting owners of the company. Preferred stock owners are nonvoting owners of the company, but receive dividends before the owners of common stock. Stock Splits A stock split is the division of a single share of stock into more than one share. Stock splits occur when the price of a stock becomes so high that it discourages potential investors from buying it. They generally favor investors who hold the stock Reverse stock splits can also occur—if the value of stock seems diluted or the company wishes to redeem shares Potential Risks in Buying Stock The firm selling the stock may encounter economic downturns that force dividends down or reduce the stock’s value. It is considered a riskier investment than bonds. Recent accounting scandals have plagued the markets, sapping the confidence of investors Even so, staying in the stock market for the long run seems to be the best financial decision. The biggest risk is NOT INVESTING. Investment Approaches Conservative—concentrate on highly rated stock and fixed income investments. Main goal: Beat inflation but don’t lose principal. EX: Retirees Moderate—Take risks by going into growth stocks, mutual funds, bonds. EX: Younger people with years to work. The closer you get to retirement, the less risk you want. Investment firms vary widely in the advice they give in allocating your financial resources. Also, you have to decide what risk you’re comfortable with. Speculative—Take major risks in hopes of striking it rich. High volatility (sudden swings in value) stocks How Stocks are Traded A stockbroker is a person who links buyers and sellers of stock. Stockbrokers work for brokerage firms, or businesses that specialize in trading stock. Some stock is bought and sold on stock exchanges, or markets for buying and selling stock. E-Trade and Ameritrade now make it possible for individual investors to place trade orders How to Buy Stock (Long) Suppose you think NBC is a strong company, makes good television programs Determine the Parent Company: General Electric Research the company; see if the fundamentals are strong in all components Look up the stock symbol (GE) Purchase the stock if you think it is a good value—you must go through a stockbroker unless you trade online (which is still going through a broker) Tips on Purchasing Stock: What to Look For Recommendations by analysts, commentators Low P/E ratio, at/off 52 week high*, undervalued company Strong company earnings (EPS or dividends or both) Company news: New products, advantages over competitors, favorable market conditions or legislation EX: Corning (GLW), Level Three (LVLT), Valero (VLO) M&A Activity: Generally the acquiring company goes DOWN in the short run and hopefully up in the long run (acquired company usually spikes to deal price). Try to find companies that are ripe for a takeover. Insider buying and selling or company stock buybacks generally means that management feels the stock price is undervalued This is by no means exhaustive; there are many reasons, some rational and some irrational, why stocks appreciate/depreciate Selling Short You can make a profit off other people’s misery! Simply find a stock you think will decline in price Borrow SHARES of the stock from a stockholder When the price falls, repay the shares (it will take less money than you borrowed) and pocket the profit. Your risk is UNLIMITED, unlike a long position Example: Selling Short DCX stock sells for $50 a share. You borrow 100 shares ($5000) Price drops to $20 a share. You pay the stockbroker back the loan for $2000. The extra $3000 is yours to keep! But if stock appreciates, you will dig into your pocket, possibly deeply Safer way: short and ultra-short mutual funds Buying on Margin How to: Open an account with your money and broker’s money. Margin calls force you to put more cash in or sell and take the loss right then and there Organized Stock Exchanges New York Stock Exchange (NYSE): About 3,000 companies, 1,400 seats with access to the trading floor. 9:30 AM- 4 PM Mon-Fri. Only stocks for the largest and most established companies are traded on the NYSE. Examples: GM, DCX, USX. American Stock Exchange (AMEX): 1,000 companies World exchanges: FTSE (London), Nikkei (Tokyo), also Frankfort, Hong Kong, Over-the-counter Market Most shares are not traded on exchanges but in electronic over-the-counter trades. NASDAQ lists information on companies traded this way. National Association of Securities Dealers Automated Quotations (NASDAQ): focuses on newer companies, has a lot of the high tech and energy stocks. EX: Microsoft is listed here OTC Trades are executed in the same fashion as trades done on stock exchanges Futures and Options Futures are contracts to buy or sell at a specific date in the future at a price specified today. Often used with commodities (pork bellies) Options are contracts that give investors the option to buy or sell stock and other financial assets. There are two types of options: 1. Call options give buyers the option to buy shares of stock at a specified time in the future. Also called warrants. You exercise a warrant if it would help you. Often sold by companies that want to issue stock or sell reserve stock. 2. Put options give buyers the option to sell shares of stock at a specified time in the future. Why Do Futures Markets Exist?????????????????????? Some people simply like trading this way Others need to lock in a firm price—DCX needs to know what the cost of steel will be for an entire run of cars. They are willing to pay a little bit more for an assurance that the price will not rise for the life of a contract. That way, they need not worry about adjusting prices and slumping demand. Measuring Stock Performance Bull and Bear Markets When the stock market rises steadily over time, a bull market exists. Conversely, when the stock market falls over a period of time, it’s called a bear market. Stock Performance Indexes The Dow Jones Industrial Average--is an index that shows how stocks of 30 companies in various industries have changed in value. The S & P 500--is an index that tracks the performance of 500 different stocks in both the NYSE and NASDAQ Also the Russell 2000, Wilshire 5000 Reasons for the 1929 Stock Market Crash/Great Depression DEPRESSION: A PHASE OF THE BUSINESS CYCLE MARKED BY INDUSTRIAL AND COMMERICAL STAGNATION, SCARCITY OF GOODS AND MONEY, LOW PRICES, AND MASS UNEMPLOYMENT STOCK MARKET CRASH IN OCTOBER 1929 DID NOT DIRECTLY CAUSE THE GREAT DEPRESSION— WHAT DID CAUSE THE DEPRESSION? · HOARDING MONEY · FEDERAL RESERVE RAISED INTEREST RATES IN 1929 · HAWLEY-SMOOT TARIFF OF 1930 · DURABLE GOODS LASTED TOO LONG: OVER-PRODUCTION PROFITS NEW PRODUCTION instead of capital improvement · EASY MONEY SUPPLY · STOCK MARKET PROBLEMS --BUYING “ON-MARGIN” --LACK OF REGULATION OF THE STOCK MARKET --SPECULATION · PSYCHOLOGY OF CONSUMPTION · THE GOLD STANDARD= RIGID MONEY SUPPLY; ECONOMY SUSCEPTIBLE TO HOARDING · STICKY WAGES/STICKY PRICES · DEPRESSION GOES WORLDWIDE: AUSTRIA’S MAIN BANK COLLAPSES IN 1931 · AMERICAN PEOPLE BLAME? 3 “B’s” BANKERS, BROKERS, BUSINESSMEN The Great Crash of 1929: Results of “Black Thursday” The Crash contributed to the Great Depression during which many people lost jobs, homes, and farms. Americans also became wary of buying stock. As recently as the early 1980s, only about 25 % of households in the United States owned stock. Around 2000, it was almost 50%. It’s going down slightly now. Joe Kennedy story. Market crashes and “adjustments” continue to spook some people, but important changes have been made to avoid huge 1-day losses SEC Created, along with Glass-Steagall Banking Act (now repealed by 1999’s Gramm-Leach-Riley Law) Effects of crashes can also be mitigated--In October 1987, for instance, the Fed simply opened its monetary spigots and a major economic downturn was avoided. “Crash” Safeguards (After 1987) A crash may be dangerous because emotions often rule people, not their heads. A selling frenzy could cause people to go nuts. Trading happens so fast there isn’t time to think. Computers can trade millions of shares in an instant. The 1987 crash (Black Monday) was precipitated by computer trades that sunk the market very quickly. As a result, new rules were instituted to delay a downturn, or at least make it happen over several days. 150 pt. swing either way shuts off program trading— this is referred to as a “market curb” (“Curbs in”). Curbs end when the market approaches 70 pt range of the previous day’s close. When the Dow loses a certain # of points, the “circuit breaker” goes off and markets shut down to let people’s emotions cool. It then reopens, but if it falls significantly, the market will close for the day. Market Circuit Breakers Before 1:00 p.m. 1:00 p.m. 1:59 p.m. 2:00 p.m. 2:29 p.m. 2:30 p.m. or later 10% Decline in the Dow 1 Hour Halt 1 Hour Halt ½ Hour Halt No Halt; If Decline Continues To 20% Then Close For Day 20% Decline in the Dow 2 Hour Halt 1 Hour Halt Close For Day Close For Day 30% Decline in the Dow Close For Day Close For Day Close For Day Close For Day Computing Annual Return Problem: In January 1996, I put $3000 into the stock market. My broker took his commission of $120 off the top. In January 1998, I sold the mutual fund shares to get money for college. I received $4500. What was my annual return and the return of the fund? (Gross Profit or loss) / (Purchase Price) / (years) = Annual Return (1500)/ (3000)= 50%/ (2 years)= 25.0% Return for me (1620)/ (3000)= 54%/ (2 years)= 27.0% for fund Losses generate negative numbers. Dow 30 Components 3M Co. (NYSE: MMM) (conglomerates, "manufacturing") ALCOA Inc. (NYSE: AA) (aluminum) Altria Group, Inc. (NYSE: MO) (tobacco, foods) American International Group, Inc. (NYSE: AIG) (property & casualty insurance) American Express Co. (NYSE: AXP) (credit services) AT&T Inc. (NYSE: T) (telecoms) Boeing Co., The (NYSE: BA) (aerospace/defense) Caterpillar, Inc. (NYSE: CAT) (farm & construction equipment) Citigroup, Inc. (NYSE: C) (money center banks) Coca-Cola Co. (NYSE: KO) (beverages) E.I. du Pont de Nemours & Co. (NYSE: DD) (chemicals) Exxon Mobil Corp. (NYSE: XOM) (major integrated oil & gas) General Electric Co. (NYSE: GE) (conglomerates, media) General Motors Corporation (NYSE: GM) (auto manufacturers) Hewlett-Packard Co. (NYSE: HPQ) (diversified computer systems) Home Depot, Inc. (NYSE: HD) (home improvement stores) Honeywell International, Inc. (NYSE: HON) (conglomerates) Intel Corp. (NASDAQ: INTC) (semiconductors) International Business Machines Corp. (NYSE: IBM) (diversified computer systems) JPMorgan Chase and Co. (NYSE: JPM) (money center banks) Johnson & Johnson Inc. (NYSE: JNJ) (consumer and health care products conglomerate) McDonald's Corp. (NYSE: MCD) (restaurant franchise) Merck & Co., Inc. (NYSE: MRK) (drug manufacturers) Microsoft Corp. (NASDAQ: MSFT) (software) Pfizer, Inc. (NYSE: PFE) (drug manufacturers) Procter & Gamble Co. (NYSE: PG) (consumer goods) United Technologies Corp. (NYSE: UTX) (conglomerates) Verizon Communications (NYSE: VZ) (telecoms) Wal-Mart Stores, Inc. (NYSE: WMT) (discount, variety stores) Walt Disney Co., The (NYSE: DIS) (entertainment) Annual Return’s not that simple though…. The method of computing return can vary— performance can be averaged or compounded. See p. 123 of supplement. We’ll save the math for the credit chapter. Return is hard to guesstimate on real estate Don’t forget taxes—they take a bite out of net return. Rule of 69.3 (aka rule of 70 and 72): 69.3/ Interest rate will tell you how long it takes for your money to double Mutual Funds Combinations of stock and/or other financial assets managed by brokerage firms New trend: Exchange traded funds can be tracked in real time (provided they don’t contain any non-stock assets) Offers diversification, scatters risk Can be broad indexes (Spiders track the SP500) EX: Powershares QQQ tracks the NASDAQ ProShares offers SHORT funds Section Review: Stocks 1. A share of stock represents (a) debt that the government or a corporation must repay to an investor. (b) a portion of ownership in a corporation. (c) a system that allows the transfer of funds between savers and borrowers. (d) a collection of financial assets. 2. Which of the following represents a way to profit from buying stock? (a) capital gains (b) portfolios (c) speculation (d) capital losses Group Critical Thinking Question Accept, reject, or modify this statement: “The United States government should allow people to invest their social security trust fund money in the market.” Consider the following: Market has returned 10%+ per year over the past 50 years—even counting recessions Market soared 50% in early 1990s Market has lost roughly 20% in last 4 years Currently social security earns 1-1.5%. Inflation has been negligible, but June ’02 was 6%. If people lose retirement money, they’re in trouble! Should there be age or other restrictions/regulations? Caps on what you can risk in the market? A Word about Asset Allocation The newest idea in the CFP world is “rebalancing.” In other words, keep your portfolio VALUE at 50% stocks and 50% bonds. If stocks decline, bonds usually go up. Sell some bonds and buy more stock, or vice versa. Stock prices and Bond Yields move in tandem Higher bond prices=lower yields This means that stock prices and bond prices move INVERSELY When one of your assets appreciates considerably, take some money off the table and move it Also, if you like a stock, add to your position slowly Bulls make money, bears make money, hogs get slaughtered Concluding Thoughts Where to look for advice? TV-FOX Business Block, CNBC Mad Money, Fast Money, Worldwide Exchange, Squawk Box, Magazines-like Money, Fortune Websites like TheStreet.com, Motley Fool, MSN Money, Yahoo SEC Website can give you insider trade filings: http://www.sec.gov/cgibin/browse-edgar?company=&CIK=&type=4&owner=include&count=40&action=getcurrent Papers: Investor’s Business Daily, Wall St. Journal Watch the operations of the Fed. Reserve. Rate cut=stocks up Now, we’ll learn how to read a stock index and a bond index. Go to page 134 in the supplemental reader.