INVESTING &
THE STOCK
MARKETS
Chapter 11
INVESTING & FREE ENTERPRISE
 Investing is essential to the free
enterprise system.
 It promotes economic growth and
contributes to a nation’s wealth. –
HOW?
 People deposit money into a savings
account and the bank lends this
money to businesses.
 Businesses can then increase
production, which leads to
expansion and growth.
FINANCIAL SYSTEMS
 Financial systems are established in an economy so investments
can take place.
 When people save money they are really loaning it to other
people.
 Savers receive a document, such as a passbook or a bond
certificate, that confirms their purchase or deposit.
 These documents represent the claims, or financial assets, of
the borrower.
FINANCIAL INTERMEDIARIES
 Financial intermediaries, including banks and other financial
institutions, accept funds from savers to make loans to
investors.
SHARING RISKS
 Dealing with financial intermediaries
offers three advantages:
 Sharing risk
 Providing information
 Providing liquidity
 Sharing risk
 Don’t put all your eggs in one basket!
 Diversification allows you to spread out your investments so that
you don’t put all of your money into one single investment.
 Sharing risk helps ward against losing everything on a bad
investment.
TYPES OF RISK
Investors must weigh the risks of investment
against the potential rate of return on their
investment.
 How does diversification lessen the risks described in
the chart?
RETURN AND RISK
THE HIGHER THE RISK, THE HIGHER THE POTENTIAL RETURN!
 The safer the investment,
the lower the return.
 Whenever people evaluate
their potential investments,
they must balance the risks
involved with the rewards
they expect to gain.
 Some investments, like
CDs, are very safe since
they are gov’t- insured
 Investing in a new
business is far riskier, but
… if it’s a success, the
return could be very big.
INVESTMENT ALTERNATIVES
• BONDS = a way to save $
and earn interest
• Businesses and governments
borrow $ through issuing of
bonds
• A bond is an IOU
• Investor “loans” $ to
corporation/government, holds
bond until maturity date, then
gets paid back at par value
• Just like any loan, the borrower
pays interest – the coupon rate to the lender – usually via a
coupon every 6 months
• U.S. savings bonds paid
differently – all at end.
• Bond ratings: Standard & Poor’s,
Moody’s
– Higher the bond rating, the lower the
interest rate it will pay
• Risk? Liquidity? Return?
Corporate Bonds
U.S. Savings
Bonds
Municipal
Bonds
INVESTMENT ALTERNATIVES
• Certificates of Deposit (CDs)
– Loans from investors to banks
– Investors can choose maturity date
• Usually 6 months, two years, three years, etc.
• Can deposit as little as $100
– Severe $ penalties for early withdrawal
– Risk? Liquidity? Return?
• IRAs – Individual Retirement Accounts
– Way to save for retirement
– Set aside $3000/year – no taxes on this
income so puts off paying taxes until worker
is retired (& then in a lower tax bracket)
– High $ penalties if cashed in early
– Risk? Liquidity? Return?
INVESTMENT ALTERNATIVES
• A professionally managed type of
collective investment scheme that
pools money from many investors
to buy securities (stocks, bonds,
etc.)
• Have a staff of analysts
• Investors like them because:
– Gives them a diversified
portfolio
– Experts are keeping up with the
investments
– They pay dividends
– Slow to change in value
– Risk? Liquidity? Return?
WHAT ARE YOU REALLY GETTING
WHEN YOU BUY A STOCK?
Part ownership… but no
real control
A certain amount of risk
Faith in the financial
reporting
Fairly liquid investment
Only a paper value until
sold
What to look for when picking stocks…
• Company information
• News articles
• Numbers: dividends; charts –
price/volume trends
• Analyst reports
• Annual/quarterly reports
• Insider buying/selling
COMMON STOCK
•
•
•
•
Most widely held type of stock
Confers voting rights: 1 share = 1 vote
May attend company annual meeting
May raise concerns to Board of
Directors
• May receive dividends
• Last in line for assets in a bankruptcy
TYPES OF STOCK
PREFERRED STOCK
• Bought like any stock
• Dividends, if any, go to preferred
shareholders first and are
“guaranteed”
• Generally has no voting rights
• Ahead of common stock for
liquidated assets in bankruptcy
“WALL STREET” ...
$ Refers in general to the markets in the
U.S. for stock trading
$ It is where financial trading began in
colonial America.
$ It is home to our oldest stock exchange,
the New York Stock Exchange
WHAT IS AN EXCHANGE?
$ It simply refers to the meeting place
- physical or virtual - for buyers and
sellers of stocks & bonds (a/k/a
“securities”)
$ In a stock exchange, representatives
of buyers & sellers meet to trade on
behalf of their customers.
$ These exchanges function as auction
markets.
MAJOR U.S. STOCK EXCHANGES:
$ New York Stock Exchange - NYSE
$ is the oldest & largest in U.S.
$ is located at 11 Wall Street, NY, NY
$ “Blue Chip” stocks listed here
$ American Stock Exchange - AMEX
$ younger companies are listed here
$ lots of energy companies listed
$ located in NY also -- just a few blocks
from NYSE
The Trading Floor of the New York Stock Exchange
How is this exchange different?
$ NASDAQ - National Association of
Securities Dealers Automated
Quotations
$ is an electronic market -- no floor
trading / phone & computer only
$ is our second largest market
$ is based in Washington, D.C.
$ Primary focus -technology stocks
Securities & Exchange
Commission
$ The SEC
$ Government agency responsible
for overseeing the stock market
$ Established after the 1929 Crash
$ Function is to make sure
investors are informed & to help
prevent cheating in stock
transactions
$ Prospectus required before stock
purchases
THE “DOW”
$ Is the Dow Jones Industrial Average
$ Takes the average of 30 stocks to
determine whether the market traded up
or down for the day (compared to a
previous average)
$ Serves as a “thermometer” & gives a
quick reading of the market’s temperature
• It is compiled daily by Dow Jones &
Company (owner of the Wall Street Journal)
• Investors use the Dow to compare the
performance of their stocks
• Dow was originally 12 stocks. The only
stock in the original 12 Dow stocks that is
in the 30 Dow stocks today is GE
The 30 Stocks of the Dow Jones Industrial Average
THE IMPACT OF 9-11 ON THE DOW
What’s the difference between
a Bull and a Bear Market?
Bull market – prices
climbing over an
extended period of time
Bear market – prices falling over
an extended period of time
Other Ways of Making Money in the Market
Margin buying – you believe a stock will rise
Buying with
borrowed money
Buying on margin works like this:
– You could buy stock with only a 10% down
payment (1,000 shares, $10/share = total cost of
$10,000 but you just put 10%/$1,000 down)
– You borrow the remaining 90% ($9,000) from the
stockbroker
– Then, when the price goes up ($20/share for ex.,
you sell it ($20,000) & pay off broker ($9,000) and
keep the remaining profit ($11,000)
– BUT, when stock values start going down,
everybody tries to sell & prices keep plummeting
– Broker then sells off your stock (for ex., at $5 per
share- $5,000) & gets less than what you owe him
– Now you have no stock, and still owe $4,000 on
your loan to the broker
– So … what type of market do you need if you
want to use margin buying?
Other Ways of Making Money in the Market:
Short selling – you believe a stock price will fall
Selling with borrowed stock –
Borrow stock, not $, then sell to “cover”
the stock you borrowed.
Short selling works like this:
– You borrow stock from the broker (1000 shares) –
this is what you have to return to him…1000
shares
– You sell the borrowed stock – for ex., at $10 per
share – and you are expecting the stock value to
continue to go down (you now have $10,000)
– When the prices do go down (let’s say to $5 per
share), you now “cover” your stock loan and buy
1000 shares to repay the stock to the broker
– You made a $5,000 profit off stock you never
owned!
– BUT, when stock prices start going up, you have a
problem
– If you had to buy back the stock at $12 for
example, your cost would be $12,000 and you
would be $2,000 down on this transaction
Should you diversify your stocks?
How lucky do you feel?
Had been dubbed “America’s Most
Innovative Company” but in 2001 it died
out in a bankruptcy wrapped up in
accounting fraud, criminal charges, and
the destruction of employee investments
and retirement savings.
TIP: Do diversify your portfolio!
Buy different stocks so that losses in one
can be balanced by gains elsewhere.
SAVING & COMPOUND INTEREST
• THE TIME VALUE
OF MONEY HAS A
SIGNIFICANT
IMPACT ON
SAVINGS &
INVESTMENT
GROWTH:
– The more time you
have to invest,
– The more money you
have to invest,
– & the higher the rate
of interest you can
earn
• EQUALS A
GREATER RETURN
ON YOUR $
REMEMBER: THE RETURN IS THE AMOUNT
EARNED ON ONE’S SAVINGS/INVESTMENTS
• COMPOUNDING
provides even more
incentive to invest
early.
• COMPOUND
INTEREST = the $
earned on your
original deposit AND
the interest payments
you have received on
that deposit in the
past
The Rule of
72
• An easy rule to determine how much your savings
or investments can grow with compound interest.
• Just divide the interest rate into 72. The result
tells you how long it will take for your money to
double without further savings.
• For example, you have $10,000, which is earning
6% interest (after tax). 72 divided by 6 = 12.
• Every 12 years your $10,000 will double, so:
– After 12 years you have $20,000
– After 24 years you have $40,000
– After 36 years you have $80,000
Do I Have A Deal for You!

You go in for a summer job interview. The boss offers to pay
you $50 a day for a 5-day, 10-week position

OR


You can earn only one cent on the first day but have your
daily wage doubled every additional day you work.
Which option would you take?

Option A – you would earn $2,500 if you work all 50 days

Option B – if you took this offer and worked only HALF the
summer, you would earn $167,772.16……by the 30th day
you would have over $5,000,000!!!
The Time Value of $
• DOES IT REALLY MATTER WHEN YOU
START SAVING?
• Jim and Mary are both 22. They both
want to save $1000 a year for retirement.
– Mary starts saving at age 22 and saves
for 20 years, until she is 42. Mary then
quits and leaves her savings to
compound.
– Jim starts 10 years later at 32 and
saves for 33 years until age 65.
• Both earn 4% on their savings every year.
• Who do you think has more money at
age 65?
• Mary has built a fund of $76,327 at age 65.
• At age 65, Jim’s fund is $68,855,
• Jim put more money into his savings but
because Mary started early and gave her
savings more time to compound, Jim was
not able to catch up.
More on the time value ….
The sooner you start to save, the greater the benefit of compound interest!
•
•
•
•
In this example, two different
individuals--Darryl and Cheryl,
each 22 years old--have an extra
$2,000 a year to invest or spend as
they choose. Darryl opens an
Individual Retirement Account
(IRA) to start saving. Cheryl
chooses to spend her $2,000.
In this example, Darryl's IRA earns
12% per year. Darryl saves $2,000
per year for 6 years, then never
puts another cent into his IRA.
Darryl's total investment is
$12,000.
Cheryl spends her $2,000 per year
for six years. At age 28, she starts
investing $2,000 per year until she
is 65 years old (37 years). Cheryl's
total investment is $74,000 . Cheryl
earns the same 12% interest per year
that Darryl does.
Because she lost some of the time
value of money, Cheryl had to
invest an extra 31 years & an extra
$62,000 to get to the same stage by
retirement age.
Age
Darryl
Cheryl
22
$2,240
$0
23
4,509
0
24
7,050
0
25
9,896
0
26
13,083
0
27
16,653
0
28
18,652
2,240
29
20,890
4,509
30
23,397
7,050
35
41,233
25,130
40
72,667
56,993
45
128,064
113,147
50
225,692
212,598
55
397,746
386,516
60
700,965
693,879
65
1,235,339
1,235,557