Chapter 10

Investment Concepts
➢ Explain the process that individuals should
follow when investing their money.
➢ Explain the types of orders investors can
place to buy or sell securities.
➢ Compute the return on an investment.
➢ Explain the difference between an arithmetic
average return and a geometric average
return and discuss why (when) one measure
is better than the other.

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➢ Discuss how market indexes and returns
are measured.
➢ Explain how margin trading and short
selling are accomplished and when each of
these investment strategies should be used.

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➢ Investors
◦ Individuals who purchase investments with
current savings in anticipation of relatively
stable growth on average, or in the long term
➢ Speculators
◦ Individuals who search for mispriced securities
in an effort to earn “quick” abnormal returns
◦ Gamble on whether the prices of financial
assets believed to be mispriced will adjust
accordingly in the market

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 Determine risk tolerance
level
(attitude toward risk)

Monitor the
Investment Define and modify
position Investment objectives/goals

Implementation to achieve
Investment objective

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➢ Investment objectives
1. Retirement planning
2. Supplement current income
3. Shelter current income from taxes
4. Achieve future goals

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➢ Investor’s attitude toward risk
◦ Risk averse investors
–Require higher returns to invest in risker
investments
◦ Risk tolerance level
–An investor’s ability and willingness to tolerate,
or accept, risk

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➢ Transaction costs
◦ The costs associated with trading securities,
which include the costs of time, effort, and
phone calls, as well as brokerage commissions
that are incurred
➢ Investment portfolio
◦ A combination of investment instruments
➢ Asset allocation
◦ The proportion of funds invested in various
categories of investments

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➢ To make sure goals are met
➢ To adjust to changing economic and legal
conditions
➢ To include new investment instruments

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➢ Brokerage firms versus financial
intermediaries
◦ Broker/ Dealers (
–Broker : Agent who sends clients’ orders on securities
markets
–Dealers : financial companies that commit to
providing liquidity by quoting bid/ask prices on
securities
◦ Financial intermediaries
–Banks, credit unions, and S&Ls
–Manufacture financial products such as mortgages,
automobile loans, or pension funds
–Allow savers to indirectly provide funds to borrowers

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➢ Brokerage firms
◦ Full-service brokerage firm
–Offers a variety of services to its clients, including
research information, monthly publications that
contain investment recommendations, advisory
services, etc...
- Fairly expensive
◦ Discount brokerage firm
- Offers clients only the basic services associated
with trading securities (execution and reporting)
- Cheaper « execution only » service
- Or also « soft dollar » access to third party
research or othe services

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➢ Trading securities
◦ Trading quantities
–Round lots—multiples of 100 shares
–Odd lots—trades with shares that are not in
multiples of 100

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➢ Trading securities
◦ Types of orders
- Limit order—order to buy or sell a stock at a
specified price or better (typically can’t be executed
immediately, wants to buy lower or sell higher than
current market conditions)
- Market order—order to execute a transaction at the
best price available when the transaction reaches
the market
- Stop order—specifies the price at which an order to
buy or sell at the market price (a market or limit order)
is initiated (risk management strategy: accept to buy at
a higher price or sell at a lower price to limit losses)
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➢ Trading securities
◦ Types of orders
Day order (DO)—instruction to cancel an order if
–
the price conditions are not met by the end of the
trading day
Good ‘til cancelled (GTC)—indicates an order is
–
active until the price limitations are met or until
the investor cancels it
Fill or kill order—instructs the broker to either
–
execute the full order or not at all

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➢ Trading securities
◦ Evidence of ownership
Physical possession of shares registered in your
–
name (stock certificate)
Often the brokerage firm holds shares in street
–
name (registered to the brokerage firm)

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➢ Trading securities
◦ Security insurance
Provided by most brokerage firms
–
SIPC limit of $500,000—insurance against theft
–
Additional limits from private organizations
–

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➢ Value Line Investment Survey
➢ Moody’s Investment Services
➢ Standard and Poor’s
➢ Periodicals
◦ Newspapers
◦ Magazines
➢ Many sources available on the Internet

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➢ StockPrice Quotations
The Wall Street Journal
April 25, 2014

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➢ Corporate Bond Quotations from The Wall
Street Journal, April 25, 2014

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➢ Individual security

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➢ Holding period return (HPR)
◦ The return earned over the period of time an
investment is held

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➢ Dividend yield
◦ The part of the total return associated with the
dividends paid by the firm
◦ = Dividend/(Stock price)
➢ Capital gain (loss) yield
◦ Percentage change in the market value of a security
◦ = (P1 – P0)/ P0

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➢ Annualized rate of return

r =
INC + (P1 - P0 )  360 = APR
P0 T

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We prefer to state returns on an annual basis so that the return on
alternative investments can be compared

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➢ Simple arithmetic average return
◦ Computed by summing each return and then
dividing by the number of returns
◦ Does not consider compounding

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➢ Geometric average return
◦ Computed by taking the nth root of the growth
multiple and subtracting 1.0
◦ Takes into account interest compounding

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➢ Computing the historical return on a portfolio

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➢ Dow Jones Industrial Average (DJIA)
◦ 30 largest firms in the U.S.
➢ Standard & Poor’s family of indexes
◦ S&P 500, S&P 400, S&P Industrials
➢ Exchange indexes
◦ NYSE, AMEX, NASDAQ
➢ Russell 3000
➢ Wilshire 5000

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➢ Price-weighted
◦ Include one share of stock in the index
◦ Could be biased by high-priced stock
➢ Value-weighted
◦ Based on market capitalization, which is the total
market value of a firm’s stock
◦ Computed by multiplying the number of shares
outstanding by the market price per share

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➢ Bull market
◦ Rising stock market
➢ Bear market
◦ Falling stock market

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➢ Buy-and-hold strategy
◦ Strategy where investors purchase securities with
the intent of holding them for a long period,
perhaps a number of years
➢ Margin trading
◦ Type of trade that allows an investor to borrow
from his or her broker some portion of the funds
needed to purchase an investment

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➢ Margin trading
◦ Margin requirement
–The minimum percent of the total purchase price
an investor must “put up” to buy stock (or other
investments) on margin
◦ Hypothecation agreement
–Assigns securities as collateral for a margin loan
◦ Broker loan rate
–The rate charged by brokers to borrow funds for
margin trading

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➢ Margin trading
◦ Actual margin
The percentage of investor’s equity (money) in the
–
investment
Must meet the margin requirement when the stock is
–
purchased

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If the value of the stock increases to $60:

$60 × 120 = $7 200

$1 233 − $5 333
)*+,- . / 0 = = 23%
$5 333

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Therefore, Karen can purchase $10 000, or 200 shares ($10 000 / $50
= 200 shares) of MVP if she fully margins her position. To do so, she
must borrow $4 000 from her broker to add to her $6 000.

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➢ Margin trading
◦ Actual margin

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➢ Margin trading
◦ Margin call
A call from the broker to add more funds to a
–
margined account

Margin call price = Amount borrowed

(per share)  Number    1− Maint enance 
   
 of shares   margin 
◦ Maintenance margin
The lowest actual margin the broker will permit
–
margined investors to have at any time

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➢ Short selling
◦ Type of trade that allows an investor to borrow the
stock of another investor and then sell it, but with a
promise to replace the stock at a later date

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➢ What process should individuals follow when
investing their money?
◦ Determine the investment objective; determine the
acceptable risk; create the investment position;
and continuously monitor the investment
➢ What types of orders can investors place
to buy or sell securities?
◦ Market order, stop order, day order, good-til-
canceled order, fill or kill order

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➢ How is the return on an investment determined?
◦ The sum of the income yield and the capital gains yield
that the investment generates during a particular period
➢ What is the difference between the arithmetic
average return and the geometric average
return?
◦ The arithmetic average equals the sum of all the
annual returns divided by the number of returns
◦ The geometric average is computed by taking the nth
root of the growth multiple and subtracting 1.0

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➢ How are market returns measured?
◦ By market indexes—Dow Jones, Standard & Poor’s
➢ What is margin trading and short selling?
◦ Margin trading—investors borrow some of the
money invested in securities from their brokers
◦ Short selling—investors borrow stocks of other
investors with the promise to return the stocks at
a later date

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