THIRTEENTH EDITION

INVESTMENTS

Analysis and Management

Charles P. Jones, Ph.D., CFA

Gerald R. Jensen, Ph.D., CFA

WILEY

PART ONE BACKGROUND
I Understandrins Investments, I
An Overall Perspective on Investing, 1
Establishing a Framework for Investing, 3
Some Definitions, 3
A Perspective on Investing, 3
Why Do We luvest?, 3
Take a Portfolio Perspective, 4
The Importance of Studying Investments, 4
The Personal Aspects, 4
Investments As a Profession, 6
Understanding the Investment Decision
Process, 8
The Basis of Investment Decisions—Return
and Risk, 8
Checking Your Understanding, 12
Structuring the Decision Process, 12
Important Considerations in the Investment
Decision-Making Process, 13
The Great Unknown, 13
A Global Perspective, 14
The Importance of the Internet, 15
Individual Investors versus Institutionell
Investors, 16
Ethics in Investing, 17
Checking Your Understanding, 18
Organizing the Text, 18
Summary, 19
Questions, 19
Spreadsheet Exercises, 20
Checking Your Understanding, 20
1 Investment Alternatives, 11
Organizing Financial Assets, 22
Direct Investing, 23
A Global Perspective, 24
Nonmarketable Financial Assets, 25
Money Market Securities, 26
The Treasury Bill, 26
Money Market Rates, 27
Checking Your Understanding, 28
Contents
Capital Market Securities, 28
Fixed-Income Securities, 28
Bonds, 28
Types of Bonds, 31
Government Agency Securities, 33
Returns on Fixed-Income Securities, 40
Checking Your Understanding, 40
Equity Securities, 40
Preferred Stock, 40
Common Stock, 41
Investing Globally in Equities, 45
Checking Your Understanding, 46
Private Equity, 46
Derivative Securities, 47
Options, 47
Futures Contracts, 48
A Final Note, 49
Summary, 49
Questions, 50
Problems, 51
Spreadsheet Exercises, 51
Checking Your Understanding, 53
1 Indirect Investing, 54
Investing Indirectly, 55
What Is an Investment Company?, 56
How Important are Investment Companies to
Investors?, 56
Three Major Types of Investment Companies, 57
Closed-End Investment Companies, 57
Exchange-Traded Funds (ETFs), 58
ETFs Versus ETNs, 59
Mutual Funds (Open-End Investment Companies), 60
Checking Your Understanding, 63
Types of Mutual Funds, 63
Money Market Funds, 64
Equity Funds, Bond Funds, and Hybrid Funds, 65
Checking Your Understanding, 69
Net Asset Value per Share, 69
The Details of Indirect Investing, 69
Closed-End Funds, 70
Mutual Funds, 70
vi CONTENTS

Investing in Index Mutual Funds Versus ETFs, 74 The Globalization of Markets, 105
Weighting Methodsfor Index Funds, 74 Summary, 105
Checking Your Understanding, 75 Questions, 106
Investment Company Performance, 75 Problems, 107
Measures of Fund Performance, 75 Computational Problems, 108
Morningstar Ratings, 77 Spreadsheet Exercises, 108
Benchmarks, 78 Checking Your Understanding, 110
Fund Performance and Expenses, 78
Some Conclusions about Fund Performance, 78 5 How Securities are Traded, 111
Investing International^ through Investment Introduction, 111
Companies, 80 Brokerage Transactions, 112
Fund Categories for International Investing, 80 Brokerage Firms, 112
The Future of Indirect Investing, 81 Brokerage Accounts, 114
Fund Supermarkets, 81 How Orders Work, 115
Hedge Funds, 81 Trading on Today's Exchanges, 115
Summary, 82 Orders in the NASDAQ Stock Market, 116
Questions, 83 Modem-Day Trading, 116
Computational Problems, 84 Types of Orders, 117
Spreadsheet Exercises, 84 Clearing Procedures, 118
Checking Your Understanding, 86 Checking Your Understanding, 119
Investor Protection in the Securities Markets, 119
4 Securities Markets and Market Government Regulation, 119
Indexes 87 Seif-Regulation, 121
The Importance of Financial Markets, 87 Other Investor Protections, 122
The Primary Markets, 88 Checking Your Understanding, 123
Initial Public Offerings (IPOs), 88 Margin, 123
The Investment Banker, 89 How Margin Accounts can be Used, 124
A Global Perspective, 91 Margin Requirements and Obligations, 124
Checking Your Understanding, 92 Margin Requirements on Other Securities, 126
The Secondary Markets, 92 Some Misconceptions about Margin, 126
U.S. Securities Markets for the Trading of Equities, 92 Short Sales, 126
The New York Stock Exchange, 93 Selling Short as an Investor, 129
The NASDAQ Stock Market, 94 Checking Your Understanding, 131
NYSE Versus NASDAQ, 95 Summary, 131
The OTC (Over-the-Counter) Market, 95 Questions, 132
BATS, 95 Problems, 132
Electronic Communication Networks (ECNs), 96 Computational Problems, 133
Foreign Markets, 97 Spreadsheet Exercises, 133
Checking Your Understanding, 97 Checking Your Understanding, 134
Stock Market Indexes, 97
The Dow Jones Averages, 98 MRT TWO PORTFOLIO AND CAPITAL MARKET
Standard & Poor's Stock Price Indexes, 100 THEORY
Understanding a Capitalization-Weighted Index, 100
NASDAQ Indexes, 101 # The Returns and Risks from
Other Indexes, 102 Investing* 135
Using the Correct Domestic Stock Indexes, 102 An Overview, 136
Foreign Stock Market Indicators, 103 Return, 136
Checking Your Understanding, 104 The Two Components of Asset Returns, 136
Bond Markets, 104 Measuring Returns, 138
Individual Investors and Bond Trading, 105 Total Return, 138
Derivatives Markets, 105 Cumulative Wealth Index, 141

A Global Perspective, 142
International Returns and Currency Risk, 142
Checking Your Understanding, 145
Summary Statistics for Returns, 145
Arithmetic Mean, 145
Geometrie Mean, 145
Arithmetic Mean versus Geometrie Mean, 147
Inßation-Adjusted Returns, 148
Checking Your Understanding, 149
Risk, 149
Sources of Risk, 150
Measuring Risk, 151
Variance and Standard Deviation, 152
Risk Premiums, 154
Checking Your Understanding, 154
Realized Returns and Risks from
Investing, 155
Total Returns and Standard Deviationsfor the
Major Financial Assets, 155
Cumulative Wealth Indexes, 156
Understanding Cumulative Wealth
as Investors, 158
Compounding and Discounting, 159
Summary, 159
Questions, 160
Demonstration Problems, 161
Problems, 164
Computational Problems, 165
Spreadsheet Exercises, 166
Checking Your Understanding, 167
1 Portfolio Theory, 169
Dealing with Uncertainty, 169
UsingProbabilities, 170
Probability Distributions, 170
Calculating Expected Return for
a Security, 172
Calculating Risk for a Security, 173
Checking Your Understanding, 174
Introduction to Modern Portfolio
Theory, 174
Portfplio Return and Risk, 175
Portfolio Expected Return, 175
Portfolio Risk, 177
Analyzing Portfolio Risk, 177
Risk Reduction—The Insurance Princxple, 177
Diversification, 178
Checking Your Understanding, 179
The Components of Portfolio Risk, 179
Covariance, 179
The Correlation Coefficient, 180
CONTENTS vii
Checking Your Understanding, 184
Calculating Portfolio Risk, 184
The Two-Security Case, 184
The n-Security Case, 187
Checking Your Understanding, 187
Obtaining the Data, 188
Simplifying the Markowitz Calculations, 188
Summary, 189
Questions, 190
Problems, 192
Computational Problems, 193
Spreadsheet Exercises, 194
Checking Your Understanding, 196
8 Portfolio Selection and Asset
Allocation, 197
Building a Portfolio Using Markowitz
Principles, 197
Identify Optimal Risk-Return
Combinations, 198
The Attainable Set of Portfolios, 198
Selecting an Optimal Portfolio of Risky
Assets, 200
The Global Perspective—International
Diversification, 2Ol
Some Important Conclusions about the
Markowitz Model, 202
Checking Your Understanding, 202
Selecting Optimal Asset Classes—The Asset
Allocation Decision, 203
Asset Allocation and Diversification, 204
Some Major Asset Classes, 204
Combining Asset Classes, 207
Asset Allocation and the Individual
Investor, 209
Life-Cycle Analysis, 212
Other Approaches, 212
Checking Your Understanding, 213
The Impact of Diversification on Risk, 213
Systematic and Nonsystematic Risk, 214
How Many Securities are Needed to Fully
Diversify?, 215
The Implications of Reducing Risk by Holding
Portfolios, 216
Summary, 216
Questions, 217
Problems, 218
Spreadsheet Exercises, 218
Checking Your Understanding, 221
viii CONTENTS
9 Capital Harket Theory and Assel
Pricing Models, 111
Capital Market Theory, 223
Capital Market Theory Assumptions, 223
Introduction of the Risk-Free Asset, 224
Risk-Free Borrowing and Lending, 225
Checking Your Understanding, 227
The Capital Market Line, 227
Defining The Capital Market Line, 227
TheSeparation Theorem, 227
Understanding the CML, 229
The Equationfor the CML, 229
lmportant Points about the CML 230
Checking Your Understanding, 230
Systematic Risk and Beta, 231
Above- and Below-Average Beta Stocks, 232
In Summary, What is Beta?, 232
Estimating Beta, 233
The Capital Asset Pricing Model (CAPM), 236
Checking Your Understanding, 239
Implementing the CAPM, 240
Tests of CAPM, 240
Arbitrage Pricing Theory, 241
The Law of One Price, 242
Assumptions of APT, 242
Factor Models, 242
Understanding the APT Model, 243
Identifying the Factors, 244
UsingAPT in Investment Decisions, 245
Checking Your Understanding, 245
Other Prominent Factor Models, 245
Some Conclusions about Asset Pricing, 247
Summary, 247
Questions, 248
Demonstration Problems, 249
Problems, 250
Computational Problems, 251
Spreadsheet Exercises, 252
Checking Your Understanding, 253
PART THREE COMMON STOCKS: ANALYSIS,
VALUATION, AND MANAGEMENT
11 Common Stocks: Analysis and
10 Common Steck Valuation, 154
Overview, 255
Discounted Cash Flow Models, 256
Two Broad DCF Approaches, 257
The Dividend Discount Model, 258
Applying the DDM, 258
The DDM Equation, 259
Implementing the DDM, 259
Estimating Future Dividends, 259
Checking Your Understanding, 260
Growth Rate Cases for the DDM, 260
The Zero-Growth Rate Model, 260
The Constant-Growth Rate Model, 261
How k and g Affect Value, 262
The Multiple-Growih Rate Model, 264
Dividends, Dividends—What about Capital Gains?, 268
The Dividend Discount Model in Practice, 269
Checking Your Understanding, 269
Other Discounted Cash Flow Approaches, 269
Free Cash Flow to Equity, 270
Free Cash Flow to the Firm, 270
Intrinsic Value and Market Price, 271
Checking Your Understanding, 272
The Multiplier Approach, 272
Lamings Multiplier (P/E Ratio), 272
Other Multipliers, 273
Price to Book (P/B), 274
Price to Sales (P/S), 274
Price to Cash Flow (P/CF), 274
Enterprise Value To EBITDA (EV/EBITDA), 274
Relative Valuation Metrics, 275
Price/Earnings (P/E) Ratio, 275
Price/Book (P/B) Ratio, 276
Price/Sales (P/S) Ratio, 276
Price/Cash Flow (P/CF) Ratio, 277
Enterprise Value/EBITDA (EV/EBITDA) Ratio, 277
Economic Value Added Analysis, 277
Which Approach To Use?, 278
Bursting the Bubble on New Economy
Stocks—A Lesson in Valuation, 279
Checking Your Understanding, 280
Some Final Thoughts on Valuation, 280
Summary, 280
Questions, 281
Demonstration Problems, 282
Problems, 284
Computational Problems, 286
Spreadsheet Exercises, 287
Checking Your Understanding, 288
Strategy, 189
A Global Perspective, 289
The Impact of the Overall Market on Stocks, 290
Building Stock Portfolios, 291
Checking Your Understanding, 292
The Passive Strategy, 292
Buy-and-Hold Strategy, 293
Index Funds, 293
 CONTENTS ix

Checking Your Understanding, 296 PART FOUR SECURITY ANALYSIS

The Active Strategy, 296
Security Selection, 297 II Economy/HarketAnalysis, 119
Rotation Strategies, 302 Introduction, 339
Market Tinning, 304 Taking a Global Perspective, 340
Checking Your Understanding, 306 Assessing the Economy, 340
Rational Markets and Active Strategies, 306 The Business Cycle, 341
A Simple Strategy: The Coffeehouse Forecasts of the Economy, 344
Portfolio, 306 Checking Your Understanding, 347
Summary, 307 The Stock Market and the Economy, 347
Questions, 307 The Economy and Stock Market Booms, 348
Problems, 308 Economic Slowdowns and Bear Markets, 348
Computational Problems, 308 Checking Your Understanding, 349
Spreadsheet Exercises, 308 Understanding the Stock Market, 349
Checking Your Understanding, 309 A Model of Aggregate Stock Prices, 349
Checking Your Understanding, 352
11 Market Efficiency, 111 Making Market Forecasts, 352
Overview, 311 Focus on the Important Variables, 352
The Concept of an Efficient Market, 312 Checking Your Understanding, 355
What Is an Efficient Market?, 312 Using the Business Cycle to Make Market Forecasts, 355
Why the U.S. Stock Market Can Be Expected to The E/P Ratio and the Treasury Bond Yield, 356
Be Efficient, 313 Summary, 358
The International Perspective, 314 Questions, 359
Forms of Market Efficiency, 315 Problems, 360
Checking Your Understanding, 317 Computational Problems, 360
How to Test for Market Efficiency, 317 Spreadsheet Exercises, 360
Weak-Form Tests, 318 Checking Your Understanding, 361
Semistrong-Form Tests, 319
Strong-Form Evidente, 321 14 Sector/Industry Analysis, IM
Checking Your Understanding, 322 Introduction, 363
Market Anomalies, 322 What Is an Industry?, 363
Earnings Announcements, 322 Gassifying Industries, 364
Low Price Multiples, 324 The NAICS Classification System, 364
The Size Effect, 325 Other Industry Classifications, 364
The January Effect, 325 The Importance of Sector/Industry Analysis, 365
Past Stock Return Performance, 326 Why Sector/Industry Analysis Is Important over
The Value Line Ranking System, 327 the Long Run, 365
Other Anomalies, 328 Checking Your Understanding, 366
Data Mining, 328 Sector Performance over Shorter Periods, 367
Checking Your Understanding, 329 How One Industry can Have a Major Impact
Behavioral Finance, 329 on Investors: The Telecom Industry, 368
Efficient Markets versus Behavioral Finance, 331 Cross-Sectional Volatility Has Increased, 368
Behavioral Finance Implications for Investors, 331 Analyzing Sectors/Industries, 369
Behavioral Finance Today, 332 The Industry Life Cycle, 369
Checking Your Understanding, 332 Checking Your Understanding, 371
Some Conclusions about Market Qualitative Aspects of Industry Analysis, 371
Efficiency, 332 Using Sector/Industry Analysis as an
Summary, 335 Investor, 372
Questions, 336 Assess the Business Cycle, 372
Problems, 337 Review Investment Advisory Services about
Checking Your Understanding, 337 Industries, 374
 x CONTENTS

Sector Rotation, 374 Checking Your Understanding, 416

Evaluating Future Industry Prospects, 374 Stock Price and Volume Techniques, 416
Summary, 376 The Dow Theory, 416
Questions, 376 Charts of Price Patterns, 418
Checking Your Understanding, 377 Checking Your Understanding, 422
Moving Averages, 423
15 Company Analysis, 378 Relative Strength, 424
Fundamental Analysis, 378 Using the Computer for Technical Analysis, 425
The Accounting Aspects of Ramings, 379 Technical Indicators, 425
The Financial Statements, 379 Breadth Indicators, 425
Checking Your Understanding, 386 Sentiment Indicators, 426
The Problems with EPS, 386 Testing Technical Analysis Strategies, 428
Reported Earnings, 386 The Ebb and Flow of Technical
Has the Situation Improved?, 387 Analysis, 430
Checking Your Understanding, 390 Some Conclusions about Technical
Using the Financial Statements to Analyze Analysis, 430
a Companys FCF, ROE, and EPS, 390 Summary, 432
Analyzing Free Cash Flow (FCF), 390 Questions, 432
Analyzing Return on Assets (ROA), 391 Computational Problems, 433
Analyzing Return on Equity (ROE), 392 Checking Your Understanding, 433
The Accounting Determinants of EPS, 393
Estimaäng the Internal (Sustainable) Growth Rate, 393 PART FIVE FIXED-INCOME SECURITIES: ANALYSIS,
Checking Your Understanding, 395 VALUATION, AND MANAGEMENT
Earnings Estimates, 395
A Forecast of EPS, 395 17 Bond Yields and Prices, 434
The Accuracy of Earnings Forecasts, 395 Introduction, 434
Earnings Surprises, 396 Bond Yields and Interest Rates, 435
Earnings Guidance, 397 The Basic Components of Interest Rates, 435
The Earnings Game, 397 The Term Structure of Interest Rates, 437
Useful Information for Investors about Earnings Risk Premiums (Yield Spreads), 440
Estimates, 398 Measuring Bond Yields, 442
Alternatives to Earnings, 399 Current Yield, 442
The Multiplier, 399 Yield to Maturity, 443
The P/E Ratio, 399 Yield to First Call, 445
Determinants of the P/E Ratio, 400 Realized Compound Yield, 446
Determinants of the P/B Ratio, 400 Checking Your Understanding, 448
Determinants of the P/S Ratio, 401 Checking Your Understanding, 450
Why Price Multiples Vary among Companies, 401 Bond Prices, 451
The PEG Ratio, 402 The Valuation Principle, 451
Fundamental Security Analysis in Practice, 402 Bond Valuation, 451
Summary, 405 Bond Price Changes, 453
Questions, 406 Bond Price Changes over Time, 453
Problems, 406 Bond Price Changes As a Result of Interest Rate
Computational Problems, 407 Changes, 454
Spreadsheet Exercises, 409 Checking Your Understanding, 457
Checking Your Understanding, 411 Summary, 457
Questions, 457
16 Technical Analysis, 411 Problems, 459
Introduction, 412 Computational Problems, 460
What Is Technical Analysis?, 413 Spreadsheet Exercises, 461
A Framework for Technical Analysis, 415 Checking Your Understanding, 462
 CONTENTS xi

18 Bands: Analysis and Strategy, 463 Option Valuation, 505

Why Buy Bonds?, 463 A General Framework, 505
Buying Foreign Bonds, 466 Intrinsic Values and Time Välues, 506
Important Considerations in Managing a Bond Boundaries on Option Prices, 508
Portfolio, 467 The Black-Scholes Model, 510
Understanding the Bond Market, 467 Put Option Valuation, 513
Global Factors and the U.S. Bond Markets, 467 Summarizing the Factors Affecting Options Prices, 513
Checking Your Understanding, 468 Hedge Ratios, 513
Bond Strategies and Techniques, 468 Using the Black-Scholes Model, 514
Passive Management Strategies, 468 Checking Your Understanding, 514
Buy and Hold, 469 An Investors Perspective on Puts and Calls, 514
Indexing, 470 What Puts and Calls Mean to Investors, 514
Active Management Strategies, 471 The Evolutionary Use of Options, 515
Forecasting Changes in Interest Rates, 471 Stock Index Options, 516
Yield Spread Analysis, 472 The Basics of Stock Index Options, 516
Identifying Mispricing among Bonds, 473 Strategies with Stock Index Options, 517
New Tools for Individual Investors, 474 The Popularity of Stock Index Options, 519
Managing Price Volatility, 474 Summary, 519
Duration, 475 Questions, 520
Checking Your Understanding, 482 Problems, 520
Managing Price Volatility, 482 Computational Problems, 522
Immunization, 482 Spreadsheet Exercises, 523
Summary, 485 Checking Your Understanding, 523
Questions, 486
Problems, 487 10 Futures Contracts, 515
Computational Problems, 488 An Overview of Futures Markets, 525
Spreadsheet Exercises, 488 Why Futures Markets?, 525
Checking Your Understanding, 489 What 1s Traded in the Futures Markets?, 527
The Structure of Futures Markets, 527
U.S. Futures Exchanges, 527
MRT SIX DERIVATIVE SECURITIES
Foreign Futures Markets, 529
19 Options, 490 The Clearinghouse, 529
Why Have Derivative Securities?, 491 Checking Your Understanding, 530
Why Options Markets?, 491 The Mechanics of Trading, 530
Introduction to Options, 491 Futures Contracts, 530
Long-Term Options, 492 Basic Procedures, 531
WeeklysSM Options, 492 Margin, 532
Understanding Options, 493 Checking Your Understanding, 534
Options Terminology, 493 Using Futures Contracts, 534
Checking Your Understanding, 493 Hedgers, 534
How Options Work, 494 How to Hedge with Futures, 535
The Mechanics of Trading, 495 Speculators, 536
Checking Your Understanding, 497 Calcülating Rate of Return on Futures Contracts, 537
Payoffs and Profits from Basic Option Positions, 497 Checking Your Understanding, 537
Calls, 497 Financial Futures, 537
Puts, 499 Foreign Currency Futures, 538
Some Basic Options Strategies, 502 Interest Rate Futures, 539
Covered Calls, 502 Stock-Index Futures, 541
Protective Puts, 503 Single Stock Futures, 546
Portfolio Insurance, 504 Summary, 547
Checking Your Understanding, 505 Questions, 548
xii CONTENTS
Problems, 549
Computational Problems, 549
Checking Your Understanding, 550
MRT SEYEN INVESTMENT MANAGEMENT
11 Hanaging Your Financial Asseis, 551
A Perspective on Investing in Financial
Assets, 551
Managing Your Financial Assets, 552
Individual Investors Vary Widely, 553
Checking Your Understanding, 553
Formulate an Appropriate Investment
Strategy, 553
Investor Objectives, 554
Assessing Your Risk Tolerance, 555
Establishing Your Return Expectations, 555
Checking Your Understanding, 557
What Issues Do Investors Face in Their
Financial Flanning?, 557
Liquidity Needs, 557
Time Horizon, 557
Tax Considerations, 558
Regulations, 559
Unique Individual Circumstances, 559
Investor Expectations as a Part of Financial
Flanning, 559
Rate of Return Assumptions, 559
Checking Your Understanding, 562
Implementing Investing Strategies, 562
Asset Allocation, 562
Portfolio Optimization, 564
Basic Investment Management Strategies, 564
Financial Flanning on an Ongoing Basis, 565
Tax-Advantaged Investing, 566
Monitoring Market Conditions, 566
Checking Your Understanding, 567
Rebalancing a Portfolio of Financial Assets, 567
Determining the Success of Your Financial
Flanning, 567
Summary, 568
Questions, 568
Spreadsheet Exercises, 571
Checking Your Understanding, 572
11 Evaluation of Investment
Performance, 5/4
A Framework for Evaluating and Assessing
Portfolio Performance, 575
Performance Measurement Issues, 575
Three Questions to Answer in Measuring Portfolio
Performance, 576
Return Calculations, 578
Risk Considerations, 580
Checking Your Understanding, 581
Performance Benchmarks and Performance
Universes, 581
Performance Universes, 581
Performance Benchmarks, 582
A Straightforward Approach to Performance
Evaluation, 582
Risk-Adjusted Measures of Performance, 583
The Sharpe Ratio, 583
Treynor's Reward to Volatility, 585
Checking Your Understanding, 586
Jensen's Alpha, 586
Information Ratio, 588
M2, 589
Sortino Ratio, 590
Checking Your Understanding, 591
Style Analysis and Performance
Attribution, 591
Style Analysis, 591
Performance Attribution, 593
Money Managers and Performance
Presentations, 593
Checking Your Understanding, 594
An Overview on Performance
Evaluation, 594
Summary, 595
Questions, 595
Problems, 597
Computational Problems, 599
Spreadsheet Exercises, 601
Checking Your Understanding, 602
Glossary, 601
Index, 611