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Chapter 2

Chapter 2. The Investment Process. Investing Overview. 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 .

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Chapter 2

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  1. Chapter 2 The Investment Process

  2. Investing Overview • 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. • Investors have their own investment objectives & strategies • The Investment Policy Statement (IPS): Designed to reflect your objectives &strategies • Two parts: 1) Objectives, 2) Constraints

  3. Objectives: Risk &Return • In formulating investment objectives, the individual must balance return objectives with risk tolerance. • Investors must think about risk &return. • Investors must think about how much risk they can handle. • Your risk tolerance is affected by: • Your ability to take risk • Your willingness to take risk

  4. 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 &legal restrictions?

  5. Investment Strategies &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?

  6. 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 that asset allocation is more important. • About 90% of portfolio performance from asset allocation. • Only 10% of portfolio performance from security selection • How is this result possible? Consider the Crash of 2008. • Bonds outperformed stocks in 2008 • Even those elusive “skilled stock pickers” might underperform bonds because stocks tend to move together

  7. The most fundamental decision of investing is the allocation of your assets: How much should you own in stock? How much should you own in bonds? How much should you own in cash reserves? . . . That decision [has been shown to account] for an astonishing 94% of the differences in total returns achieved by institutionally managed pension funds. . . . There is no reason to believe that the same relationship does not also hold true for individual investors. John Bogle of Vanguard Says

  8. Choosing a Broker/Advisor • What do you do after carefully crafting your Investment Policy Statement (IPS)? • 3 groups/types of brokerage account, & broker/advisor: • Full-service brokers • Discount brokers • Deep-discount brokers • These groups can be distinguished by the level of service provided, & the level of commissions charged. • Online investing has changed the brokerage industry. • Slashing brokerage commissions • Providing investment information • Customers place buy and sell orders over the Internet

  9. Advisor-Customer Relations • There are several important things to remember when you deal with any broker/advisor: • Any advice you receive is not guaranteed. • Your broker works as your agent and has a legal duty to act in your best interest. • Brokerage firms, however, do make profits from brokerage commissions and/or annual fees.

  10. Two Types of Brokerage Accounts • A Cash accountis a brokerage account in which securities are paid for in full. • A Margin accountis a brokerage account in which, subject to limits, securities can be bought &sold shorton credit (more on selling short later)

  11. (a) Open the account (b) Deposit $10,000 (c) Buy 100 Shares of Nordstrom (JWN) at $63 per share (d) Pay Commission, Say $50 (e) Cash Account has: $3,650 in Cash $6,300 in Stock A Cash Account

  12. Margin Accounts • In a margin purchase, the portionof the value of an investment that is not borrowedis called the margin. • 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.

  13. Ex: Margin Accounts, The Balance Sheet • You buy 1,000 Pfizer (PFE) 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%

  14. Margin Accounts • In a margin purchase, the minimum marginthat must be supplied is called the initial margin. • The maintenance margin is the margin amount that must be present at all times in a margin account. • When the margin drops below the maintenance margin, the broker can demand more funds. This is known as a margin call.

  15. Ex: The Workings of a Margin Account, I. • Your margin account requires: • an initial margin of 50% amaintenance margin of 30% • A Share in Miller Moore (WHOA) is selling for $50. • Have $20,000& want to buy as much shares as you can. • You can buy up to $20,000 / 0.5 = $40,000 worth of WHOA.

  16. Ex: 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.

  17. Ex: 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?

  18. 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?

  19. 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. Ex: How Low Can it Go? • Suppose you want to buy 300 shares of Pepsico(PEP) at $55 per share. • Total cost: $16,500 • You have only $9,900—so you must borrow $6,600. • Your initial margin is $9,900/$16,500 = 60%. • Suppose your maintenance margin is 40%. At what price will you receive a margin call?

  21. The margin call occurs when the price of Pepsico hits $36.67. How so? Ex: How Low Can it Go? (Answer)

  22. Ex: Annualizing Returns on a Margin Purchase, I. You buy 1,000 shares of Wal-Mart (WMT) at $60 per share. • Your initial margin is 50%. • You borrow at the 9% call money rate plus 2%. • You sell your shares 3 months later for $63 per share. • There were no dividends paid (and suppose the prices above are net of commissions). What is your holding period percentage return and your EAR?

  23. 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

  24. Annualizing Returns on a Margin Purchase, III. Note that there are 12/3 = 4 three-month holding periods in a year. Therefore, m = 4.

  25. Other Account Issues • 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.

  26. Borrow shares from someone Sell the Shares in the market Buy shares From the market Return the shares Today In the Future Short Sales An investor with a long position benefits from price increases. • Ex: You buy today at $34 &sell later at $57, you profit! • Buy low, sell high • Short Sale is a sale in which the seller does not actually own the security that is sold. An investor with a short position benefits from price decrease • Ex: You sell today at $83, and buy later at $27, you profit. • Sell high, buy low

  27. You short 100 shares of AT&T (T) at $30 per share. An initial margin 50% & a 40% maintenance margin The value of stock borrowed that will be sold short is: $30 × $100 = $3,000 Ex: Short Sales, I.

  28. AT&T 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% Ex: Short Sales, II.

  29. AT&T 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. Ex: Short Sales, III.

  30. More on Short Sales • Short interest is the amount of common stock held in short positions. • In practice, short selling is quite common &a substantial volume of stock sales are initiated by short sellers. • Note: you may lose more than your total investment, as there is no limit to how high the stock price may rise. • Short Sellers face Constraints. • From government intervention (i.e., the SEC) • there might not be enough shares available to borrow to short sell. • Constraints reduce liquidity, increase volatility& lead to inefficient pricing.

  31. Forming a Real Investment Portfolio • Take the Risk Tolerance Quiz in the textbook. • What score did you get? • What does your score mean?

  32. AAII Asset Allocation Models

  33. Useful Internet Sites • money.msn.com/how-to-invest (a reference for portfolio building) • www.cfainstitute.org (a reference for a career in financial advice) • www.cfp.net(another reference for a career in financial advice) • Risk Tolerance Quizzes: • www.fool.com • www.individual.ml.com • money.msn.com • www.sipc.org (a reference to learn all about the SIPC) • www.finra.org (a reference for dispute resolution) • www.brightscope.com (a reference to compare 401(k) plans) • www.bearmarketcentral.com (a reference devoted to short selling) • www.AAII.net.com (a reference for investing as an individual) • www.reit.com (a reference to learn more about REITs) • jmdinvestments.blogspot.com(reference for recent financial information)

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