Section 7: Investments Overview
Concepts you’ll learn
1.
2.
3.
4.
5.
6.
7.
8.
Stocks
Stock Indices
Bonds
Rate of Return
Investment Risk
Diversification
Mutual Funds
Commissions and Fees
Problems you’ll solve
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Define major investment vehicles
Classify investments with respect to general rate of return and risk
Understand how to manage risk through diversification
Understand how risk management goals vary depending personal
circumstance
Understand how to minimize transactions costs
©2014 D. M. Kaufman. All rights reserved
Investments – Definitions
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Stock: A type of security that signifies ownership in a corporation and represents a claim on part of
the corporation's assets and earnings. There are two main types of stock: common and preferred. Common
stock usually entitles the owner to vote at shareholders' meetings and to receive dividends. Preferred stock
generally does not have voting rights, but has a higher claim on assets and earnings than the common shares. For
example, owners of preferred stock receive dividends before common shareholders and have priority in the event
that a company goes bankrupt and is liquidated.
Stock Index: An aggregate value produced by combining several stocks or other investment vehicles together
and expressing their total values against a base value from a specific date. Market indexes are intended to
represent an entire stock market and thus track the market's changes over time.
Index values are useful for investors to track changes in market values over long periods of time. For
example, the widely used Standard and Poor's 500 Index is computed by combining 500 large-cap U.S. stocks
together into one index value. Investors can track changes in the index's value over time and use it as a
benchmark against which to compare their own portfolio returns.
Bond: A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows
the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states
and U.S. and foreign governments to finance a variety of projects and activities.
Rate of Return: The gain or loss on an investment over a specified period, expressed as a percentage increase
over the initial investment cost. Gains on investments are considered to be any income received from the security
plus realized capital gains.
Investment Risk: The chance that an investment’s actual return will be different than expected. This includes
the possibility of losing some or all of the original investment. Risk is usually measured by calculating the standard
deviation of the historical returns or average returns of a specific investment.
A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk
that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to
be compensated for taking on additional risk.
For example, a U.S. Treasury bond is considered to be one of the safest investments and, when compared
to a corporate bond, provides a lower rate of return. The reason for this is that a corporation is much more likely
to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher, investors are
offered a higher rate of return.
Diversification: A risk management technique that mixes a wide variety of investments within a portfolio. The
rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield
higher returns and pose a lower risk than any individual investment found within the portfolio.
Mutual Fund: An open ended fund operated by an investment company which raises money from shareholders
and invests in a group of assets, in accordance with a stated set of objectives. Mutual funds take the money they
receive from investors (along with any money made from previous investments) and use it to purchase various
investment vehicles, such as stocks, bonds, and money market positions. In return for the money they give to the
fund when purchasing shares, shareholders receive an equity position in the fund and, in effect, in each of its
underlying securities. For most mutual funds, shareholders are free to sell their shares at any time, although the
price of a share in a mutual fund will fluctuate daily, depending upon the performance of the securities held by the
fund. Benefits of mutual funds include diversification and professional money management. Mutual funds offer
choice, liquidity, and convenience, but charge fees and often require a minimum investment.
Commission: A service charge assessed by a broker or investment advisor in return for providing investment
advice and/or handling the purchase or sale of a security. Most major, full-service brokerages derive most of their
profits from charging commissions on client transactions. Commissions vary widely from brokerage to brokerage.
Looking At the Grand Scheme...
Intel
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Fidelity U.S.
Bond Index
(mutual fund)
Fidelity Total
Market Index
(mutual fund)
Dow
Jones
Index
S&P 500
JDS
Uniphase
Notice that individual stocks can give you either the best or the worst returns,
depending on when you buy and when you sell (and market timing is very
difficult).
A bundle of stocks (in this case, the stock indices) tend to give the best returns
over long time periods, but they can go down in value over the short term
Bonds tend to stay slow and steady, but they give a stronger likelihood of
preserving your principal or cost basis
Basic Scenario Planning
• Let’s say you’re saving money to buy a car in five
years. Which type of investment would you pick?
t1
t1
During these 5 years:
• INTC earned the most
• The stock indices yielded decent gains
• We don’t have bond data for this
period, but they likely would
have yielded modest gains
t2
t2
During these 5 years:
t3
• JDSU exploded
• INTC did very well
• The stock indices yielded
very good gains
• Bonds yielded modest gains
t3
During these 5 years:
• JDSU tanked
• INTC declined sharply
• The stock indices
declined slightly
• Bonds yielded modest gains
Notice that the highest risk, highest return choices don’t
always play out the best over limited time horizons
Basic Scenario Planning (cont.)
• Let’s say, in 1997, you start saving for retirement
in 2030. Which type of investment would you pick?
So far:
• JDSU would have first elated and then killed you (you’d have less money overall).
• INTC would have you slightly up – and it could tank at any time, since it’s just one stock.
• The stock indices are slightly up, and are somewhat protected from sharp declines by
diversification – if bad news hits any one stock the general market is unlikely to be affected. Of
course, the entire market can still decline in value (as it did from 2000 through 2003).
• The bonds have just plugged along at the bottom – earning very modest (but positive) returns.
In this hypothetical, you still have time on your side
Basic Scenario Planning (cont.)
• Let’s say, in 1998, you invest $500,000 towards retirement
in 2003. Which type of investment would you pick?
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JDSU would be a disaster
INTC would have you slightly down
The stock indices are basically flat – you’d pretty much have what you started with
The bonds have just plugged along – but your money would have grown slightly
In this hypothetical, the individual stocks = disaster and the stock indices are still
risky. Bonds do a better job of growth + capital preservation as retirement looms.
Let’s Zero In a Bit
• Notice anything interesting about the peaks highlighted
here?
• The two individual stocks have the sharpest peaks, while the indices are more muted. Why?
• There is a whacky regression statistic called “beta,” which is a measure of risk associated with a given stock.
• The entire stock market, with all its diversification across thousands of stocks, is defined as having a beta of
1. A stock with a beta greater than 1 will typically exhibit larger percentage swings (both positive and
negative) than the market. A stock with a beta less than one will exhibit lower percentage swings than the
market. A stock with a beta of 1 will typically track the market.
• The two individual stocks listed here are considerably more risky than the market. Higher risk is more richly
rewarded in good times and more severely punished in bad.
More on Mutual Funds and Fees
• As stated on the “definitions” page, mutual funds
provide a quick path to diversification (avoiding the
extreme peaks and valleys we saw on the previous
page).
– i.e. To diversify a stock portfolio by buying 1 share of each S&P 500
company (that’s 500 different shares of stock), you’d have to pony up tens
of thousands of dollars, and even then your investment would not be value
weighted. In order to achieve value weighting, you’d have to pony up
hundreds of thousands.
– With a mutual fund, you can achieve the same goal with only a few
hundred dollars, because you can essentially buy fractional shares.
• Furthermore, you can avail yourself of professional
money management with mutual funds, depending on
the fund’s prospectus, but...
• ...beware of management fees.
• Speaking of fees, understand that, in general, the more
money management services you engage, and the more
often you buy and sell securities, the more commissions
and fees you will pay.
• We’ll talk in more detail about all of this over the next
few sections.
So, A Few Guidelines...
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Diversification is key to managing risk
There are various levels of diversification
1.
2.
3.
4.
Most risky: investing 100% in a single stock
Very risky: investing 100% in a handful of stocks
Risky: investing 100% in stocks, stock mutual funds, and stock indices
Moderately risky: investing in a balance of stocks (and/or stock mutual
funds ad indices) and highly rated bonds and/ bond mutual funds. Junk
bonds are a different story, and we’ll talk more about those later.
5. Less risky: investing in a balance of stocks (and/or stock mutual funds and
indices), bonds and/or bond mutual funds, and savings instruments (i.e.
the savings accounts, money markets, and CDs discussed in the previous
section).
6. Less risky still: investing in bonds and/or bond mutual funds, and savings
instruments.
7. Are you really that afraid of life?: investing in savings instruments only.
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Where you fall on this risk/reward spectrum should
depend on your age and your investment goals. See the
next page
Potential Portfolio Mix Examples
Young, with no near or mid
term needs to withdraw or
spend your money on
5%
95%
Still young, but with a few major
planned expenditures coming up
in the next few years
Stocks
Bonds
Cash Equ.
Major stuff on the horizon. Perhaps
paying for kids’ college, or
retirement in the next few years, etc.
20%
40%
40%
Stocks
Bonds
Cash Equ.
20% 10%
70%
Stocks
Bonds
Cash Equ.
Retired. Still want some
potential growth but need to
preserve capital.
20%
20%
60%
And don’t forget to properly diversify within each asset class.
“20% stocks,” for example, doesn’t necessarily mean 20% of
your portfolio invested in one single stock.
Stocks
Bonds
Cash Equ.
Section 7: Practice Problem
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Start thinking about how you’d want your investment
portfolio to look under the following scenarios (because
you’ll be constructing a virtual portfolio in the next
couple of weeks). How would you diversify across the
major asset classes if:
1.
2.
3.
4.
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You’re
You’re
You’re
You’re
young and single, with 40+ years until retirement.
young and married with 2 kids, with 30+ years until retirement.
middle aged, with about 10 years until retirement.
retired.
Spend the most time thinking about scenario 1 – that’s
what you’ll build your virtual portfolio around.
Section 8: Stocks (Details)
Concepts you’ll learn
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
Share Price
Volume
Bid-Ask Spread
Shares Outstanding
Market Cap
Corporate Earnings or Net Income
P/E Ratio
Dividends
Splits
Sectors
Moving Average
Quarterly Earnings Report
Brokerage account
Market Order
Limit Order
Stop Loss Order
Short Selling
Capital Gain
Margin
Problems you’ll solve
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Understand key stock health indicators
Calculate returns associated with stock investments
Understand how to diversify a stock portfolio across sectors and cap sizes
Understand how to minimize transactions costs
©2014 D. M. Kaufman. All rights reserved
Public Service Announcement
The point of this section is to teach you how to
evaluate stocks as long-term investments, not
for short-term speculation. There is no safe
way to “place bets” on stocks for short-term
gains. Some (lucky) people get rich doing it,
but many (unlucky ones) go broke. If you
want to risk everything you’ve got on shortterm time horizons you may as well go to
Vegas.
So, if anyone asks you whether you learned to
“bet” on stocks in this class, the answer is no.
But you may learn how to invest in them.
Stocks – Definitions
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Share Price: The price of one share of stock
Volume: The number of shares or contracts traded in a security or an entire market
during a given period of time. It is simply the amount of shares that trade hands from
sellers to buyers as a measure of activity. If a buyer of a stock purchases 100 shares
from a seller, then the volume for that period increases by 100 shares based on that
transaction.
Bid-Ask Spread: The amount by which the ask price exceeds the bid. This is essentially
the difference in price between the highest price that a buyer is willing to pay for an
asset and the lowest price for which a seller is willing to sell it. In general, the lower
the spread, the more liquid, or actively traded, the stock is (i.e. higher volume).
Shares Outstanding: Stock currently held by investors, including restricted shares
owned by the company's officers and insiders, as well as those held by the public.
Shares that have been repurchased by the company are not considered outstanding
stock. This is not the same as the “float,” which is the number of shares owned by the
public and available for sale.
Market Capitalization: The total dollar market value of all of a company's outstanding
shares. Market capitalization is calculated by multiplying a company's
shares outstanding by the current market price of one share. The investment
community uses this figure to determining a company's size, as opposed to sales or
total asset figures.
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Large Cap: $10 billion plus
Mid Cap: $2 billion to $10 billion
Small Cap: Less than $2 billion
Corporate Earnings: The amount of profit that a company produces during a specific
period, which is usually defined as a quarter (three calendar months) or a
year. Earnings typically refer to after-tax net income.
Price/Earnings Ratio: A valuation ratio of a company's current share price compared to
its per-share earnings. The formula is: Share Price / Earnings Per Share (EPS). EPS is
usually from the last four quarters (trailing P/E), but sometimes it can be taken from
the estimates of earnings expected in the next four quarters (projected or forward
P/E). A third variation uses the sum of the last two actual quarters and the estimates
of the next two quarters.
Quarterly Earnings Report: A quarterly filing made by public companies to report their
performance. Included in earnings reports are items such as net income, earnings per
share, earnings from continuing operations and net sales.
Stocks – Definitions (cont.)
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Dividend: A distribution of a portion of a company's earnings, decided by the board of
directors, to a class of its shareholders. The dividend is most often quoted in terms of
the dollar amount each share receives (dividends per share). It can also be quoted in
terms of a percent of the current market price, referred to as dividend yield.
Stock Split: A corporate action in which a company's existing shares are divided into
multiple shares. Although the number of shares outstanding increases by a specific
multiple, the total dollar value of the shares remains the same compared to pre-split
amounts, because no real value has been added as a result of the split.
Sector: An area of the economy in which businesses share the same or a related
product or service, or a group of securities in the same industry or market. It’s
important to examine how a given stock is positioned relative to other stock in its
sector, and how the sector as a whole is positioned relative to the overall market.
Finally, a well diversified portfolio will contain stocks from multiple sectors.
Brokerage Account: An arrangement between an investor and a licensed brokerage
firm that allows the investor to deposit funds with the firm and place investment
orders through the brokerage, which then carries out the transactions on the investor's
behalf. The investor owns the assets contained in the brokerage account and must
usually claim as income any capital gains he or she incurs from the account.
Market Order: A buy or sell order in which the broker is to execute the order at the
best price currently available.
Limit Order: An order placed with a brokerage to buy or sell a set number of shares at
a specified price or better. Limit orders also allow an investor to limit the length of
time an order can be outstanding before being canceled.
Stop Loss Order: An order placed with a broker to sell a security when it reaches
a certain price. It is designed to limit an investor's loss on a security position.
Short Selling: The selling of a security that the seller does not own, or any sale that is
completed by the delivery of a security borrowed by the seller. Short sellers assume
that they will be able to buy the stock at a lower amount than the price at which they
sold short.
Capital Gain / Loss: An increase / decrease in the value of an asset or property.
Margin: Borrowed money that is used to purchase securities. This practice is referred
to as "buying on margin". Buying with borrowed money can be extremely risky
because both gains and losses are amplified.
Margin Call: A broker's demand on an investor using margin to deposit additional
money or securities so that the margin account is brought up to the minimum
maintenance margin.
One Last Definition: Simple Moving Averages
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A simple, or arithmetic, moving average that is calculated by adding the closing price
of the security for a number of time periods and then dividing this total by the number
of time periods. Short-term averages respond quickly to changes in the price of the
underlying, while long-term averages are slow to react.
In other words, this is the average stock price over a certain period of time. Keep in
mind that equal weighting is given to each daily price. As shown in the chart above,
many traders watch for short-term averages to cross above longer-term averages to
signal the beginning of an uptrend, but it’s less of a key indicator over the longer term.
As shown by the blue arrows, short-term averages (e.g. 15-period SMA) act as levels
of support when the price experiences a pullback. Support levels become stronger and
more significant as the number of time periods used in the calculations increases.
A stock that is trading above its SMAs is typically either overpriced or enjoying positive
earnings / business growth. You need to evaluate which is the truth.
A stock that is below its SMAs is typically either underpriced or suffering some
business setback. You need to evaluate which is the truth.
Looking At a Few Stocks
Interested in any of these?
Let’s Look Closer At INTC
1
INTC is profitable. EPS is positive, and P/E ratio equals ~45.
2
They pay a small dividend, improving returns.
3
This is a huge company; market cap > $100B.
4
High avg. volume and tight bid-ask spread suggest a very liquid
stock.
3
5
Analysts don’t expect the stock to go too much higher in the next
year (not quite 8%)
4
1
6
INTC tends to follow the market, but with a beta > 1.
5
2
7
INTC barely above its 15 and 50 day moving averages
4
7
6
4
What’s going on here? A huge, profitable
company with limited growth prospects?
Digging Deeper Into INTC
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INTC’s P/E ratio is 40+. But is that good or bad? Consider:
– Historical Index P/E ratios:
• The historical average P/E ratio for the DJI is ~12
• The historical average P/E ratio for the S&P 500 is ~15
– So, INTC is a huge company and deserves to be held to the same standard as a market
index – it is no longer a small company with potential for explosive growth.
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Why else might INTC’s near-term growth prospects be limited?
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There are still reasons why you might want to buy and hold INTC
over the long term, but you should go in with eyes wide open. Do
you think the analysts are wrong (they’ve been wrong before) and
that INTC will grow more in the next year than they believe? Or do
you think that INTC’s growth prospects beyond this year are good,
so you want to get in now?
If not, don’t put money into INTC at this time. You decide.
•
– INTC is one of a very few suppliers of microprocessors to the personal computer (PC)
market, and they dominate. So, they’re huge, but they can’t grow within the existing
PC market – the entire PC market has to grow for INTC to grow significantly.
– Even though INTC can’t grow within the current PC market, INTC’s competitors can – all
they have to do is take business away from INTC. Certain surprise announcements to
this effect are a potential driver for those occasional steep declines we see in INTC’s
stock chart, after which INTC has to claw its way back to regain lost business.
– INTC is barely above its 50 DMA (50 day moving average), suggesting the stock might
be overpriced.
– INTC’s 15 DMA looks like it’s about to cross the 50 DMA, suggesting a flat-to-down
trend. Will it continue…?
1. Invest only in stocks which you thoroughly understand.
2. If you’re not willing or able to do research like this, you have no business
picking individual stocks. Stick with mutual funds and/or indices.
Now, Let’s Look Closer At GE
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4
1
5
2
1
GE is profitable. EPS is positive, and P/E ratio equals ~13.5.
2
They pay a decent dividend, improving returns.
3
This is a huge company; market cap over $175B.
4
High avg. volume and N/A bid-ask spread suggest a very liquid
stock.
5
Analysts expect GE to decline over the next year.
6
April 11th, 2008 -- hammered! What happened??
7
GE is above its 15 and 50 day moving averages
6
7
6
Hmm. Bleaker growth prospects then INTC, but
why? And what happened on April 11th, 2008??
4
Digging Deeper Into GE
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GE’s P/E ratio is ~13.
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What in the hell happened on April 11th, 2008??
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More info:
– The historical average P/E ratio for the S&P 500 is ~15.
– The DJI historical average is ~12.
– GE’s P/E ratio is in line with historical market averages. Not bad.
– “In an interview on CNBC, CEO Jeff Immelt blamed the sudden collapse of Bear Stearns
and the worsening credit crunch for GE's earnings surprise. He also described the poor
results as a ‘bump in the road,’ though the company lowered its earnings outlook for the
entire year. -- Source: CNBC, 4/11/08
– General Electric Company (GE) operates as a technology, media, and financial services
company worldwide. It operates through four segments: GE Capital, Energy
Infrastructure, Technology Infrastructure, and NBC Universal. The GE Capital segment
offers an array of products and services that include commercial loans, operating leases,
fleet management, financial programs, home loans, insurance, credit cards, personal
loans, and other financial services. The Energy Infrastructure segment involves in the
development, implementation, and improvement of products and technologies that
harness various resources, such as wind, oil, gas, and water. The Technology
Infrastructure segment focuses on building healthcare, transportation, and technology
infrastructure. The NBC Universal segment develops, produces, and markets film,
television, news, sports, and special events. – Yahoo Finance
• So we’ve got a huge, profitable, highly diversified, international
conglomerate (paying out a small dividend) that took a beating
over a bad earnings statement and declined since at a faster
rate than the market. Long-term buying opportunity? Farther
to fall? You decide, but you’d probably have to dig even deeper
on this one. Has management gone through a bunch of recent
turnover? How does their balance sheet look? Let’s take a look
at their financial details...
And Still Deeper on GE
Okay, what have we got here...?
– Profit margins are positive (we already knew that),
but which way are they heading?
– Hmm. Quarterly revenue (total money taken in)
down by 16%+ from the same time period last
year (yoy = Year Over Year), and net earnings
shrank by almost 50%. GE’s sales are falling and
their cost of doing business must be going way up
(inflation? rising oil prices?). Will that continue?
– Whoa! They’ve got a lot of debt. What’ll happen
with that?
So, this is probably why GE hasn’t
recovered back to the market trend
line. They won’t go out of business
anytime soon and may be a good longterm investment, but is now the time
to get in? Again, you decide. 
Now, It’s WFC’s and XOM’s Turns
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We don’t need to do the same type of analysis on these guys, but let’s
say you bought both at the “last trade” prices, held them for a year,
and both exactly hit the analysts’ 1yr Targets. How much money
would you make?
– WFC:
• Your cost basis is $28.90. The 1yr target is $29.30. Your capital gain is 29.30 –
28.90 = $0.40.
• You also are expected to receive quarterly dividends totaling $0.20 for the year.
• Your total return is 0.40 + 0.20 = $0.60, or 0.60 / 28.90 = 2.08%.
– XOM:
• Your cost basis is $69.59. The 1yr target is $76.58. Your capital gain is 76.58 –
69.59 = $6.99.
• You also are expected to receive quarterly dividends totaling $1.68 for the year.
• Your total return is 6.99 + 1.68 = $8.67, or 8.67 / 69.59 = 12.46%.
– Side note: historical average stock market returns are ~8% annually, so if
the analysts are right, and the dividends hold, the return on XOM would be
pretty sweet, and WFC would be a bit weak…
– ...But, are they right? You decide.
More On Short Selling
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Short selling is almost always a risky, short term bet, and I don’t
recommend it. Here’s why:
•
Whether you think INTC is a wise investment right now or not, the
most you can lose on a share of it is ~$20. The upside, however, over
a long period of time, is unlimited.
But if you sell it short, you pay interest until you buy back, and if the
amount of money in your brokerage account drops until it’s exactly the
amount you would need to repurchase the shares (plus paying
commissions), your broker will automatically repurchase the shares to
square up your account – leaving you with about $.01. So short
selling is almost always a short term play, and...
The most you can make is ~$20/share, because you’re hoping to
repurchase at a lower price, and the price can’t go any lower than
zero. But because a stock price can rise indefinitely, the most money
you can lose as a short seller is also indefinite. That’s a losing
proposition, I think. Again, people make money doing it, but a lot also
go broke.
•
•
More on Margin Buying
• Here are some details on how it works:
– Let’s say you have $1,000 to invest. Your brokerage firm agrees to lend you
up to 50% of your total investment. So, you’re putting in $1,000, and
they’re loaning you another $1,000.
– Next, you invest the entire $2,000 in 200 shares of ABC Company at $10 a
share. You agree to keep $1,000 in assets in your account at all times to
cover this loan.
– What happens next? Let's look at two scenarios.
• Scenario 1: The stock rises to $12 a share – a 20% gain.
– You could sell the shares for $2,400 – a 40% return on your original $1,000 investment
– You would pay back the loan, with interest, and pay a sales commission to your broker
– After costs, your profits would be higher than if you had invested without borrowing.
• Scenario 2: The stock drops to $8 a share – a 20% loss
– You will have a loss of $400 on paper. You could sell the shares and take your losses, or
you could hold on to the shares in the hope that they may go up again sometime in the
future
– You still have to pay commissions to buy the stock, plus the interest on your loan
– You will also have to put money back into your investment account. Why? Your brokerage
firm only agreed to lend you up to 50% of the total you have invested. This total is now
just $1,600, down from $2,000. That means you can carry a balance of only $800 on
margin. Clearly, you are over your limit, because you owe your broker $1,000. So, you
will get a margin call to set it right. You’ll have to put $200 of your own money back into
the account. So, you’re 40% down instead of 20%, and you’re digging into pocket to buy
time until things improve, while paying interest. Sounds a lot like someone in Vegas
withdrawing money from an ATM, praying that their luck will change.
• Again, not recommended as a sound long-term
investment strategy
A Bit More on Diversification
• Let’s look again at our old friends
If we were to buy each of these, would we be diversified?
A Bit More on Diversification (cont.)
• The answer is: yes and no.
Large Cap
Large Cap
Large Cap
Large Cap
We’re diversified across sectors, but not across market cap size
A Bit More on Diversification (cont.)
• Diversification across sectors is probably the more
important of the two, because sectors tend to run
hot and cold
• Still, diversification across cap sizes can also be
desirable
– Cap sizes can run hot and cold too
– When the smaller cap companies get hot, they can provide the
most amazingly spectacular returns. You’ll never be able to time it
perfectly – that is, get in just before a hot streak begins and get
out just before it ends – but if you have a few in your portfolio at
all times, you’ll see some crazy good results every so often.
They’re also risky, but with enough diversification into larger
companies and across sectors you should still be okay over the long
haul.
Bottom line: there’s no law against investing solely in one market
cap size but, once again, diversification has its benefits
Public Service Announcement (revisited)
If you’re not already convinced that making a
bunch of risky short-term bets is less desirable
than making a few deliberate, long-term
investments, consider the following:
Each time you buy or sell a stock, you have to pay
commissions. Don’t “churn and burn” yourself.
The best way to keep your commissions and fees
low is: make a few, well thought out, long term
investments, and make them yourself with an
inexpensive online broker. Full-service brokers will
give you all kinds of advice – and charge higher
commissions for it – and may rob you blind.
Section 8: Practice Problems
1. How many shares does GE have outstanding?
2. If you owned a share of GE, what quarterly dividend would
you expect to receive?
3. If you pay the “last trade” price for a share of GE, hold it for a
year, and the analysts’ 1y target turns out to be precisely
accurate, what return will you make?
4. Would you expect GE to suffer a huge share price decline as a
result of bad earnings news in the technology sector?
5. If you sold GE short at the “last trade” price, what’s the most
per share you could earn? What’s the most you could lose?
6. If you buy 100 shares of GE at the “last trade” price on 50%
margin, and the price then increases by 25%, what would the
return on your investment be? How about if the price
decreases by 25%?
Class Exercise #2: Stock Portfolio
Rules
1. You start with $10,000 in virtual money.
2. On the day you open your portfolio (i.e. the day you present your portfolio to the
class), you’re allowed up to 10 trades.
3. The primary idea of this exercise is to select individual stocks (i.e. do your research),
but you may also elect to leave a portion of your money in cash and (or) in bonds
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–
Leaving a portion of your initial money in cash and (or) bonds doesn’t count as one of your
initial 10 trades
Money left in cash and (or) bonds will not accrue interest or yield a return. This is not true to
life, but it’s the only way to make this exercise manageable over the remainder of the course.
4. You may buy any publicly traded individual stock on the NYSE or NASDAQ
exchanges, in any full share increment.
5. You may also buy a fictional mutual fund that exactly tracks the performance of the
S&P 500, in any full penny increment. This is a magical mutual fund that doesn’t
charge any management fees.
6. After you present your portfolio to the class, your trades will be recorded.
7. We’ll track your portfolio performance every few days.
8. The one with the most money at the end of the course wins.
Grading
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You’ll be graded on the initial construction of your portfolio.
Of primary importance is your ability to defend your decisions. i.e. How much risk
are you taking on? Why? Are you diversifying with bonds and cash or jumping
headlong into stocks? Why? With respect to the stocks you purchase, are you
diversified? How? Why? Have you researched the companies thoroughly? Can you
prove it?
Final rule: you can’t pick any of the stocks contained in
the following “portfolio presentation example” foils.
©2014 D. M. Kaufman. All rights reserved
Portfolio Presentation – 2008 Example
Targeted Asset Mix
10%
30%
60%
Stocks
Bonds
Cash
•
Personal Status
•
•
College expenses for the little grommets aren’t too far off.
Retirement could be as early as ~15 years from now –
coinciding with kids’ college expenses. Ouch.
Debt free status means fixed living expenses are low – we
can take some investment risks.
Summary: Need aggressive growth from stocks while
preserving some capital for looming big-ticket expenses
and income reductions. A total or near total loss would be
devastating.
•
•
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–
–
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Age: 37
Married
Two kids, age 6 and 3
Debt free
Planning early retirement
Portfolio Presentation – Example (cont.)
•
•
•
Initial funding: $10,000
Initial investments:
–
–
–
$2,000 in cash (targeting another
$1,000 to go into stocks soon, but
holding in reserve for now)
$3,000 in bonds
$5,000 in stocks
–
–
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30 shares Disney (DIS)
35 shares Bank of America (BAC)
50 shares Pfizer (PFE)
$2,047.70 in S&P 500 Index Fund
Initial stock picks:
Portfolio Presentation – Example (cont.)
•
Stock diversity
–
–
–
–
Strong diversity across sectors with
S&P 500 position, plus heavier
positions in pharmaceuticals (PFE),
entertainment (DIS), and finance
(BAC).
Pharma and entertainment tend to
be somewhat recession proof, and
our economy is weak right now.
Finance is a contrarian position –
it’s been beaten way down and I’m
hoping for a turnaround.
All large cap positions. May miss
out on positive moves in small cap,
but today’s small cap trend is down
and I don’t want to risk outsize
losses.
Portfolio Presentation – Example (cont.)
•
Specifically, why Disney?
–
–
–
–
–
–
–
–
–
Fairly diversified as entertainment
companies go – film, TV, travel, and
merchandise.
Very strong worldwide brand.
Pixar acquisition and Steve Jobs board
seat ensures “cutting edge” adoption of
distribution technology.
Highly profitable – strong P/E ratio
Slight dividend bonus
Slight revenue growth...
...Outpaced by 9% quarterly earnings
growth yoy – this company has expenses
under control
Highly solvent (see debt/equity ratio of
~.4)
Key Risks: terrorist attack, movie flops,
Steve Jobs health
Portfolio Presentation – Example (cont.)
•
Specifically, why BAC?
–
–
–
–
–
–
–
Less exposed to the current mortgage
crises (they packaged and sold off most
of their sub-prime loans).
Hoping we’ve seen most of the bad news
in the financial sector (and earnings
growth will start to recover)
Reasonable P/E ratio
Strong earnings (negative earnings
growth notwithstanding)
Strong dividend provides a nice cushion
against potential capital loss
Betting that this company will recover
from any short term risk over the next 15
years while providing a nice dividend.
Key risks: More bad news in financials,
earnings continue to slow, BOD suspends
the dividend, (sizeable) debt becomes
unmanageable.
Portfolio Presentation – Example (cont.)
•
Specifically, why PFE?
–
–
–
–
–
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–
People will always need their medicines
Strong product pipeline
Strong earnings with amazing quarterly
earnings growth yoy (119%)
Reasonable P/E ratio
Decent dividend provides a nice cushion
against potential capital loss
Very low debt/equity ratio
Key risks: Product pipeline setbacks with
the FDA
Portfolio Presentation – Example (cont.)
Initial position summary and cost basis
Cash
Bonds
Stocks
S&P 500
DIS
BAC
PFE
TOTAL
$2,000
$3,000
$5,000
$2,047.70
$ 952.50
$ 982.80
$ 967.00
$10,000
(30 shares @ $31.75)
(35 shares @ $28.08)
(50 shares @ $19.34)
Little opportunity here for explosive growth, but
well set up for healthy gains. Given my age and
goals, that’s an okay trade off.