Principles of Investments 1th by

Michael Drew
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 Mc TM
Graw
Hill
Education

Course Principles of Investments

Course Number First Australian Edition
Zvi Bodie, Michael E.Drew,
Anup Basu, Alex Kane,
Alan J . Marcus
McGraw-Hill Education

The end of 2008 capped three decades of rapid and profound
change in the investment industry with a financial crisis of historic
magnitude. The vast expansion of financial markets over recent
decades was due in part to innovations in securitisation and
credit enhancement that gave birth to new trading strategies.
These strategies were in turn made feasible by developments in
information technology, as well as by advancements in the theory
of investments.
The crisis can be traced in part to macroeconomic imbalances
in global trading patterns. Huge savings in exporting countries fed
low interest rates and historically high leverage in business and
investment portfolios around the world. Yet the crisis was rooted
in cracks of the financial system. The innovation-driven, massive
capacity of the system to facilitate highly leveraged investments
was coupled with, and indeed enhanced by, relaxation of
regulation as well as incentive schemes that reduced transparency
and masked the overvaluation of investment assets.
These developments highlight the importance of 1wo innovations that
were coincidentally emerging in the theory of investments, namely, the
centrality of liquidity in asset valuation and the importance of investor
behaviour that contribute to herding and at times low-quality, wildly
optimistic forecasts. Broadly speaking, asset liquidity is often hard to
measure and investors may at times become overly optimistic or
pessimistic-but these are just additional factors in the assessment
and incorporation of overall market risk in asset valuation, a central
theme of this text. Still, the idea that security markets are nearly efficient,
meaning that most securities are usually priced appropriately given
their risk and return attributes, nevertheless remains a justifiably
powerful approach to security valuation. While the degree of market
efficiency is and will always be a matter of debate, this first principle of
valuation, specifically that in the absence of private information prices
are the best guide to value, is still valid. Greater emphasis on risk
analysis is the lesson we have weaved into the text.
This text also emphasises asset allocation more than most other
books. We prefer this emphasis for two important reasons. First, it
corresponds to the procedure that most individuals actually follow
when building an investment portfolio. Typically, you start with all
of your money in a bank account, only then considering how much
to invest in something riskier that might offer a higher expected
return. The logical step at this point is to consider other risky
asset classes, such as stock, bonds or real estate. This is an asset
allocation decision. Second, in most cases the asset allocation
choice is far more important than specific security-selection
Principles of Investments, First Australian Edition 3
decisions in determining overall investment performance. Asset
allocation is the primary determinant of the risk-return profile of
the investment portfolio, and so it deserves primary attention in a
study of investment policy.
Our book also focuses on investment analysis, which allows
us to present the practical applications of investment theory,
and to convey insights of practical value. In this edition we offer
a systematic collection of Excel spreadsheets that give you tools
to explore concepts in depth. These spreadsheets are available
online and provide a taste of the sophisticated analytic tools
available to professional investors.
In our efforts to link theory to practice, we also have attempted
to make our approach consistent with that of the CFA Institute.
The Institute administers an education and certification program
to candidates for the title of Chartered Financial Analyst (CFA).
The CFA curriculum represents the consensus of a committee of
distinguished scholars and practitioners regarding the core of
knowledge required by the investment professional.
'Investments' nowadays is a truly global discipline both in
theory and practice. For example, today it is impossible to imagine
an Australian fund manager to hold a portfolio comprising of
just Australian assets. In fact, doing so would go against the
tenets of modern portfolio theory and also current industry
practice. Therefore, while this text is written from an Australasian
perspective and mainly aimed at students within this geographic
region, we have included several cases and examples from other
markets around the world. As the United States is the largest
market for financial securities and also a major source of financial
data and research findings, examples from that market feature
prominently in many chapters.
This text will introduce you to the major issues of concern to
all investors. It can give you the skills to conduct a sophisticated
assessment of current issues and debates covered by both the
popular media and more specialised finance journals. Whether
you plan to become an investment professional or simply a
sophisticated individual investor, you will find these skills essential.
Zvi Bodie
Michael E. Drew
Anup Bosu
Alex Kane
Alan J. Marcus
4 Principles of Investments
xiv
ABOUT THE AUSTRALIAN AUTHORS
MICHAEL E. DREW
Griffith University
Michael Drew is a Professor of Finance
at the Griffith Business School. Michael's
research has studied and developed
new approaches to the design of the
default option in defined contribution
funds, as well as devising winning
strategies for lifecycle and target date
funds. In 2009, Michael was invited
to appear before a joint hearing of
the US Department of Labor and the
Securities Exchange Commission in
Washington DC where he presented
testimony relating to his research on
target date funds. Michael's research on
superannuation was extensively cited by
the recent Cooper Review, and has been
widely cited by industry, academic,
regulatory and government agencies.
Michael has completed numerous
consulting projects and industry
assignments, including senior roles at
QSuper and the Queensland Investment
Corporation. In 2011, Michael was
awarded the Finsia (Financial Services
Institute of Australasia) Pinnacle Award
for Most Outstanding Thought leader
to celebrate 125 years for the peak
industry body.
ANUP BASU
Queensland University of Technology
Anup Basu is a Senior lecturer of
Finance at OUT Business School. Prior
to completing his PhD and joining
academia, he worked in the financial
services industry in Asia and North
America where he served in different
management positions. Dr. Basu has
several publications on investments and
capital markets in leading academic
and professional journals. His research
has been cited by World Bank and
IMF policy research report on pension
plans, OECD Working Party on Private
Pensions, United States Government
Accountability Office, and the United
States Senate Hearing before the Special
Committee on Aging, joint hearing of the
United States Government Department
of Labor and the Securities & Exchange
Commission (SEC) and the Cooper Review
of Superannuation System in Australia.

ZVI BODIE
Boston University
Zvi Bodie is Professor of Finance and
Economics at Boston University School of
Management. He holds a PhD from the
Massachusetts Institute of Technology
and has served on the finance faculty at
Harvard Business School and MIT's Sloan
School of Management. Professor Bodie
has published widely on pension finance
and investment strategy in leading
professional journals. His books include
Foundations of Pension Finance, Pensions
in the U.S. Economy, Issues in Pension
Economics, and Financial Aspects of the
U.S. Pension System. Professor Bodie
is a member of the Pension Research
Council of the Wharton School, University
of Pennsylvania. His latest book is
Worry-Free Investing: A Safe Approach to
Achieving Your Lifetime Financial Goals.
Principles of Investments, First Australian Edition
ALEX KANE
University of California, San Diego
Alex Kane is Professor of Finance and
Economics at the Graduate School of
International Relations and Pacific Studies
at the University of California, San Diego.
He holds a PhD from the Stern School of
Business of New York University and has
been Visiting Professor at the Faculty of
Economics, University of Tokyo; Graduate
School of Business, Harvard; Kennedy
School of Government, Harvard; and
Research Associate, National Bureau of
Economic Research. An author of many
articles in finance and management
journals, Professor Kane's research is
mainly in corporate finance, portfolio
management, and capital markets.
5
ALAN J. MARCUS
Boston College
Alan Marcus is Professor of Finance
in the Wallace E. Carroll School of
Management at Boston College. He
received his PhD from MIT, has been a
Visiting Professor at MIT's Sloan School of
Management and Athens Laboratory of
Business Administration, and has served
as a Research Fellow at the National
Bureau of Economic Research, where
he participated in both the Pension
Economics and the Financial Markets
and Monetary Economics Groups.
Professor Marcus also spent two years
at the Federal Home loan Mortgage
Corporation (Freddie Mac), where he
helped to develop mortgage pricing and
credit risk models. Professor Marcus has
published widely in the fields of capital
markets and portfolio theory. He currently
serves on the Research Foundation
Advisory Board of the CFA Institute.
6 Principles of Investments

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 Principles of Investments, First Australian Edition 7

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8 Principles of Investments

LEARNING OBJECTIVES
Each chapter begins with a summary of the
chapter objectives, providing students with
an overview of the concepts they should
understand after reading the chapter.
A chapter overview follows.

CHAPTER OVERVIEW
Each chapter begins with a brief narrative to
explain the concepts that will be covered in
more depth.
I NVESTMENT
commitmen1of curren1
resources in the
expectation of deriving
greater resources In !he
future
An invQs1ment Is the current commitment of money or other resources In the expectation ol reaping
futvre benef11s For exomple. ¢.n mdivtdvol might pure.hose shores of stock onticipoting that lhe
future proceeds from lhe shares will justify both the time thol their money is lied up os well os lhe
risk of the investment The time you will spend studying this tcx.1 lnot to mention its cosU is also on
investment. You ore forgoing either curren1 let.sure time°' the uxome you could be earning ot a job in
the expectation thot yovr future co1eer will be sufflc-ently enho.nced 10 rusllfy this comm1tmen1 of hme
ond effort. While these two investments differ in many woys they share one key ottribute Ihot is central
to all investments: you sacrifice something of votue now expecting to benefit from that sacrifice later.
This te>d can help you become aninfo,med practitioner of investments. Wew,11 focus on investments
1n secutities such as shores, bonds or options ond futures conuocrs. but much of what we dJSCUSS wlll
be useful in the anatysas of any type of investment. The text will prOVide you wilh background in lhe
a<ganisation of various securilies markets, will survey the valuation ond risk·monogemenl principles
useful in particular markets, such os those for bonds or shares, and \'1itl introduce you to the principlc,s
of portfoho construction.
a,oodly speoking, lhi$ chople, oddresses lhree lopics lhot will prov,de o vselvl perspec11ve lor lhe
material that is lo come later. First. before delving into the topic of 'inveslments', we consider the ro4e
of financial assets in the economy. We discuss the relationship between securities ond the 'reoJ' ossets
thol actually produce goods and services tor consume<s and we consider why tinonetol assets are
1mpor1on1 to the functioning of the economy We inves119ote three mo1or types of finanool assets thol
form on importont par1 of mos! investment portfolios. before discussing the role of financial markets
in the wider economy. Given this background, we then take o first look at the types of decisions that
confront investors as they assemble a portfolio of osse1s.
Finally, we conclude wl1h on 1ntroduc1lon 10 rhe orgon1sohoo of security mortte1s and lhe vonous
ploye,s lhol porl,c:,po1e in lhose mor1<e1s Togelhef, lhese topies should grve you o leel 10< who lhe
major porticiponls ore in the securities markels as well as the setting in which they oct. The chapter
closes with an overview of the remainder of the text

KEY TERMS AND MARGIN MONEY MARKETS

DEFINITIONS
Key terms are indicated in colour and defined
in the margin the first time the term is used.
A glossary is available on the endmatter.
al.so play an important role as ar, indication, or bendunark, for interest rates.
An impomnt feature: of mcme)' market instruments is the face: value, o r par value. This
include shO~·term. highly
liQuid and relatively low·
nsk debt Instruments
is the amoum the borrower wiJJ repay when the innrumcnt mawrcs. J,.,ta.ny money·m:.uket
insrrumencs are discount se<:ul'ities, chat is, they are iniciaJlysold at a price ch.ea per than the fu.ce
value. Discouot securiries do 001 make periodic interest pay1neo1s, like some ocher instrumems.
FACE VALUE
The: interest sim ply ace.Tues each day. slowly increasing the value o f che instrument) at a rate::
the amount cepaid when
an instrument matures
consistent with the interest c.u ncd on the invcnmem. \\;'hen the security scnlcs, that is, ,he
loan is repaid, che pavmem includes the initial money borrowed plu.s the imcrcst that was

NUMBERED EQUATIONS
Key equations are called out in the text and
identified by equation numbers.
income: the share has p rovided . 1"he r:uc of rct11rn is defined as dollars earned over ,he i nvc:stmc:nt
period (price appreciation as well as dividends) per dollar invested.
HOLOING· PERIOO
HPR = end ing price - beginning price+ cash dividend
beginning price (5.1)
RETURN (HPR)
rate ot return over a gi\1en
investment period This definition of rhc: HPR assume:$ ,har ,he d ividend is paid :u rhc: <::nd o f rhc: holding
period. To the extent chat dividends arc received car)jcr, the definition ignores rcinvesm1ent
income between the receipl of the dividend and the end of the holding period . Recall also that
rh.e percentage return Crom dividends is called the dividend yield and so the dividend yield,
ca..'ih d ividend/beginning p rice:. plus the c.-ipi~ I gains yield equals the H PR.
lhis dehnhion of holding rcnirn is easy fO modi!)• fo r other types of invcs,mems. For
 Principles of Investments, First Australian Edition 9

ON THE MARKET FRONT

Current articles from financial publications such
as The Wall Street Journal are featured as boxed
readings. Each box is referred to within the
narrative of the text, and its real-world relevance
to the chapter material is clearly defined.

CONCEPT CHECKS You o e creol ng on 1n·,·~111e-n1 porl1o 10 and moi<1ng a chCkce be1v..eeo d ~erenl ,nv~t"llenl:. Wh,<h
Concept check 1.2 of ·he following Ole as.sel o locolion dem.i0ns and -.·,nich ore secur ty selec oo dee sions?
These self-test questions in the body of the o Bonds or c4!J•ics
b ~eol cs.tote or com.mod I es
I
chapter enable students to determine whether c BHP Bi 1on o< Ro Tinlo shores

the preceding material has been understood and

then reinforce understanding before they read
further. Detailed solutions to the Concept checks
are found at the end of each chapter.

NUMBERED EXAMPLES
EXAMPLE3.4
Numbered and titled examples are integrated in
each chapter. Using the worked-out solutions to
these examples as models, students can learn
how to solve specific problems step-by-step
as well as gain insight into general principles
MARGIN CALLS ON SHORT POSITIONS
Suppose the broker has a maintenance margin of 30% on short saJe.s. This meam the
equity in your account must be 3 t least 30% of the ,,aJuc of your short position at all
times. I low much can the price of Dot Bomb shares- rise before you ger a ma_rgin c.111?
Lee P be d\e price of Dot Bomb shares. Then rhe value of the shares you must pay
back is lOOOPand the eq uity in your ac:-count is $ 1;0 000- IOOOP. Your sho rt position
margin ratio i$ equity/value of stock = ( 150 000 - I 000/l'J/ I OOOP. The critical value of
P is rhu.s

by seeing how they are applied to answer Equity = 150000- IOOOP = 0.3
Value of sha= owed IOOOP
concrete questions.
which implies d1at P = $1 15.38 per share. If Doc Bomb share should rise above
$115.38 per share, you will get a mari,'ln call and you will either have to put up
additional cash or cover your short posit io n by buying shares to replace the ones
borrowed.
10 Principles of Investments

EXCEL APPLICATIONS Excel applications

Since many courses now require students to per- Buying on margin
1hc Excel spreadsheet model below makes it easy to analyse the impacts of different margin
••• levels a.od the volatifjl}' o f nock prices. lt also aJlows you co compare return on investment
form analyses in spreadsheet format, Excel has •••
••• for a margin trade with a trade using no borrowed funds.
been integrated throughout the book. It is used in
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to the Web to work with an interactive version of

the spreadsheet. The student can obtain the ac-
tual spreadsheet online available spreadsheets
are denoted by an icon. As extra guidance, the
spreadsheets include a comment feature that
documents both inputs and outputs. Solutions for
these exercises are available only to instructors,
so instructors can assign these exercises either
for homework or just for practice.

Excel application spreadsheets are available for the following:

Chapter 3: Buying on margin; Short sale Chapter 15: Parity and Spreads
Chapter 7: Estimating the index model Chapter 18: Performance measures; Performance attribution
Chapter 10: Immunisation; Convexity

Spreadsheet exhibit templates are also available for the following:

Chapter 5: Spreadsheet 5.1 Chapter 10: Spreadsheets 10.1 & 10.2
Chapter 6: Spreadsheets 6.1-6.7 Chapter 11: Spreadsheets 11.1 & 11.2
Chapter 9: Spreadsheets 9.1 & 9.2 Chapter 14: Spreadsheet 16.l

PROBLEM SETS
We strongly believe that practice in solving
problems is a critical part of learning investments,
so we provide a good variety, organised by level
of difficulty: Basic, Intermediate, and Challenge.
CFA PROBLEMS
We provide several questions from recent
CFA exams in applicable chapters. These
questions represent the kinds of questions that
professionals in the field believe are relevant to
the practicing money manager.
WEBMASTER EXERCISES
A great way to allow students to test their skills
on the internet. Each exercise consists of an
activity related to practical problems and real-
world scenarios.
Principles of Investments, First Australian Edit ion 11
PROBLEM SETS
QUESTIONS
Basic
1. Vilhat is the difference between an IPO OnitiaJ public offerTlg} and placement? LO 3,2
2. VI/hat are some different components of tho etfec1lve costs of buying or sel!lng shclfes? LO 3.6
3. Wtlal ,stile dlffel'Gfloa be.tween a primary and secondary ma1ke1? LO 3.3
4. A publie company can raise addi1ional capi1a1in a number or ways. Which WrJ'/ would YoV recommend to a oornpany
in1erested in raising capital Qt,.lici<fV? LO 3.t
5. What are the cifferences between a stop k>ss order, a lirrit sell order and a market order? LO 3.5
6. How do margin trades magnify both the upside potent>al and downside risk of an l'lvestment portfolio? LO 3.7
Intermediate
7. Here is some price intormati(;(l on Fi'lcorp shares. $oppose frst that Fincorp trades in a oo•r market.
Bid Asked
55.25 55.50
1. ff yov place a stop loss order to sell 100 shares of stock at $55 when the c1.Xrent price is $62, how much will
receive fo, each share ~ the pnce dr¢PS to $50?
.. $50
b. $55
c. $54.87
d. Cainno11eu from the informabOn gNen. LO 3.5
2. You wish to sell short 100 shares of XYZ C-0rDCl'ation stock. ff the last two transactions were at $34.12 lolowed by
$34.25. you can sell short on the next transaction only at a prioe of:
a. 34. 12 or higher
b. 34.25 or togher
c. 34.25 or lower
d. 34.12 or IO\IJ'Elt LO 3.8
SOLUTIONS TO CONCEPT CHECKS
Concect check 3.1.
WEB MASTER • DATA ON BOND ISSU ES
Use data from Yahoo Finance at finance.yahoo.com/bonds to answer the folowlng question.
1. Use the search feat...-e to search for five well·known US companies that issue corporate bonds. Note the bond
ratings (if possible choose companies with a wide range of bond ratings). Next use too Financials section to obtain
the companies' financiaJ reports and calc.Jate some key financial ratios. Vv11at is the relationship between boOO
rating and these ratios? can
you tell from your sample which of these ratios are the more important determrlants of
bond rating?
The FINRA cperates the TRACE (Trade Reporting and Compliance Engine) system. vklich reports over th&-oovn1er 4
secondary market trade$ of fixed inoc.ne -securities. Go to the FIN.RA. hOme page a1...11,w.•.finra.org and dick on the
link tor 'Industry Professionals'. Search ('bcated at the lop righl) tor the ·TRACE Facl Book' a,ld cliek the first link thal
appears. Find the detailed dala tatltes and local& th& tabl& w,th i0f0tmation on issues. axcluek"lg con~ bollCIS
(typically Tablo 1).
1. For each of the last three years, ca!Q..llate the following:
a. the percentage of bonds that were poolicly traded and the percentage that were pivatetf traded
b. the percentage of bonds that wG<e lnvostment grade and the pGtcentage that wem hlgh~yletd
c. the percenlag& ~ bonds thal had fixed ooupo,i rates and the percootage that had fk>aling mies.
2. Do any patterns emerge over time?
3. Repeat the calculations using the infCfmation for convertible bond issues (typically in Table 2).
12 Principles of Investments

CHAPTERS IN THIS PART

1 Investments: background and issues
2 Asset classes and financial markets
3 Securities markets
4 Managed funds and investment management

Even a cursory glance at The Australian
Financial Review reveals a bewildering
collection of securities, markets and financial
institutions. But although it may appear so,
the financial environment is not chaotic: there
is rhyme and reason behind the vast array
of financial instruments and the markets in
which they trade.
These introductory chapters provide a
bird's-eye view of the investing environment
and how markets and securities have evolved
to meet the changing and complex needs of
different participants in the financial system.
Markets innovate and compete with each
other for traders' business just as vigorously
as competitors in other industries. Competition
between the Australian Securities Exchange
(ASX), the newly established Chi-X stock
Principles of Investments, First Australian Edit ion 13
exchange and a number of electronic and
non-Australian exchanges (e.g. the New York
Stock Exchange, the London Stock Exchange)
is robust.
The explosive growth of online trading has
saved investors many millions of dollars in
trading costs. Even more dramatically, new
electronic communication networks promise
to allow investors to trade directly without
a broker. These advances will change the
face of the investments industry and market
players will scramble to formulate strategies
that respond to these changes.
These chapters will give you a good
foundation to understand the basic types of
securities and financial markets as well as
how trading in those markets is conducted.
14 Principles of Investments

CHAPTER 1

INVESTMENT An invest111ent is the current commitment of money or other resources in the expectation of reaping
commitment of current future benefits. For example, an individual might purchase shares of stock anticipating that the
resources in the future proceeds from the shares will justify both the time that their money is tied up as well as the
expectation of deriving risk of the investment. The time you will spend studying this text (not to mention its cost) is also an
greater resources in the
investment. You are forgoing either current leisure time or the income you could be earning at a job in
future
the expectation that your Mure career will be sufficiently enhanced to justify this commitment of time
and effort. While these two investments differ in many ways they share one key attribute that is central
to all investments: you sacrifice something of value now expecting to benefit from that sacrifice later.
This text can help you become an informed practitioner of investments. We will focus on investments
in securities such as shares, bonds or options and futures contracts, but much of what we discuss will
be useful in the analysis of any type of investment. The text will provide you with background in the
organisation of various securities markets, will survey the valuation and risk-management principles
useful in particular markets, such as those for bonds or shares, and will introduce you to the principles
of portfolio construction.
Broadly speaking, this chapter addresses three topics that will provide a useful perspective for the
material that is to come later. First, before delving into the topic of 'investments', we consider the role
of financial assets in the economy. We discuss the relationship between securities and the 'real' assets
that actually produce goods and services for consumers and we consider why financial assets are
important to the functioning of the economy. We investigate three major types of financial assets that
form an important part of most investment portfolios, before discussing the role of financial markets
in the wider economy. Given this background, we then take a first look at the types of decisions that
confront investors as they assemble a portfolio of assets.
Finally, we conclude with an introduction to the organisation of security markets and the various
players that participate in those markets. Together, these topics should give you a feel for who the
major participants are in the securities markets as well as the setting in which they act. The chapter
closes with an overview of the remainder of the text.
 Principles of Investments, First Australian Edition 15

CHAPTER 1 I Investments: background and issues I 5

1.1 REAL ASSETS VERSUS FINANCIAL ASSETS

The material wealth of a society is ultimately determined by the productive capacity of its
economy, that is, the goods and services its members can create. This capacity is a function of
the real assets of the economy: the land, buildings, equipment and knowledge that can be used
to produce goods and services.
In contrast to such real assets are financial assets such as shares and bonds. Such securities
are no more than sheets of paper; these assets are the means by which individuals in well-
developed economies hold their claims on real assets. Financial assets are claims to the income REAL ASSETS
generated by real assets (or claims on income from the government). assets used to produce
While real assets generate net income to the economy, financial assets simply define the goods and services
allocation of income or wealth among investors. The distinction between real and financial
FINANCIAL ASSETS
assets is apparent when we study the balance sheet of Australian households, shown in
claims on real assets
Table 1.1. Household wealth includes real assets, such as personal dwellings, and financial or the income generated
assets, such as bank accounts, corporate shares or bonds. These securities, which are financial by them
assets of households, however, are liabilities of the issuers of the securities. For example, a bond
owned by a household is considered an asset, as it gives you a claim on interest income and
the future repayment of the principal. From the perspective of the company that issued the
bond, however, it is considered a liability as it is obligated to make the interest payments along
with repaying the principal. The household's asset is the company's liability. Therefore, when
we aggregate overall balance sheets, these claims cancel out, leaving only real assets as the net
wealth of the economy.
This text will focus almost exclusively on financial assets. But you shouldn't lose sight of the
fact that the successes or failures of the financial assets we choose to purchase ultimately depend
on the performance of the underlying real assets.

Assets S billion TABLE 1.1

Real assets
Australian household
Real estate-dwel lings & investment 1 619.7 21.3% balance sheet at 30
Other non-financial assets 3 099.7 40.8% June 2011
Consumer durab les 269.4 3.5%
Total real assets 4 988.8 65.6%
Financial assets
Cash & deposits 669.1 8.8%
Insurance & superannuation reserves 1 571.5 20.7%
Corporate & other equ ity 261.9 3.5%
Other securities 94.8 1.3%
Other 5.0 0.1 %
Total financial assets 2 602.3 34.4%
Total assets 7 591.1 100.0%
Liabilities and net worth
Mortgage and other loans 1 504.5 20.5%
Source: Australian Bureau
Security cred it 24.8 0.1 % of Statistics, 'Table 41 :
Other 60.9 1.0% Household Balance Sheet,
Total liabilities 1 590.2
Current prices - as at 30
21.6%
June', Australian System of
Net worth 6 000.9 78.4% National Accounts 2010-11,
Total 7 591.1 100.0% Cat. 5204.0, ABS, Canberra.
16 Principles of Investments
6 I PART l I Elements of investments
Concept check 1.1
FIXED-INCOME (DEBT)
SECURITIES
a financial asset that pays
a specified cash flow over
a specific period
EQUITY
an ownership share in a
corporation
DERIVATIVE SECURITIES
securities providing payoffs
that depend on the values
of other assets
Are the following assets real or financial?
a. patents b. lease obligations c. customer goodwill
d. a college education e. a $5 bill
1.2 TYPES OF FINANCIAL ASSETS
It is common to distinguish among three broad types of financial assets: debt, equity and
derivatives. Fixed-income or debt securities promise either a fixed stream of income or a stream
of income that is determined according to a specified formula. For example, a corporate bond
would typically promise that the bond holder will receive a fixed amount of interest each year.
Other so-called floating-rate bonds promise payments that depend on current interest rates. An
example is a bond with an interest rate fixed at two percentage points above the rate paid on a
13-week Treasury note issued by the Reserve Bank of Australia (RBA). Unless the borrower is
declared bankrupt the payments on these securities are either fixed or determined by a formula.
For this reason, the investment performance of debt securities is not closely tied to the financial
condition of the issuer.
Nevertheless, debt securities come in a tremendous variety of maturities and payment
provisions. At one extreme, the money market refers to fixed-income securities that are short-
term, highly marketable and generally very low-risk. Examples of money market securities
are Treasury notes or bank certificates of deposit (CDs). In contrast, the fixed-income capital
market includes long-term securities such as Treasury bonds, as well as bonds issued by state
and local governments and corporations. These bonds range from very safe in terms of default
risk (e.g. Treasury securities) to relatively risky (e.g. high yield or 'junk' bonds). They also are
designed with extremely diverse provisions regarding payments provided to the investor and
protection against the bankruptcy of the issuer.
Unlike debt securities, ordinary share, or equity, in a firm represents an ownership share
in the corporation. Equity holders are not promised any particular payment. They receive any
dividends the firm may pay and have prorated ownership in the real assets of the firm. If the
firm is successful, the value of equity will increase; if not, it will decrease. The performance of
equity investments, therefore, is tied directly to the success of the firm and its real assets. For
this reason, equity investments tend to be riskier than investments in debt securities.
Finally, derivative securities such as options and futures contracts provide payoffs that are
determined by the prices of other assets such as bond or share prices. For example, a call option
on a share of ANZ shares might turn out to be worthless if ANZ's share price remains below a
threshold or 'exercise' price such as $20 a share, but it can be quite valuable if the share price
rises above that level.* Derivative securities are so named because their values derive from the
prices of other assets. For example, the value of the call option will depend on the price ofANZ
shares. Other important derivative securities are futures and swap contracts.
Derivatives have become an integral part of the investment environment. One use
of derivatives, perhaps the primary use, is to hedge risks or transfer them to other parties.
This is done successfully every day and the use of these securities for risk management is so
commonplace that the multitrillion-dollar market in derivative assets is routinely taken for
• A call option is the right co buy a share of stock at a given exercise price on or before the option's expiration dace. If the market
price of ANZ remains below $20 a share, the right co buy for $20 will turn out co be valueless. If the share price rises above
$20 before the option expires, however, the option can be exercised co obtain the share for only $20.
 Principles of Investments, First Australian Edition 17

CHAPTER 1 I Investments: background and issues I 7

granted. However, derivatives can also be used to take highly speculative positions. Every
so often, one of these positions blows up, resulting in well-publicised losses of hundreds of
millions of dollars. While these losses attract considerable attention, they do not negate the
potential use of such securities as risk management tools. Derivatives will continue to play an
important role in portfolio construction and the financial system. We will return to this topic
later in Part 5.
In addition to these financial assets, individuals might invest directly in some real assets. For
example, real estate or commodities such as precious metals or agricultural products are real
assets that might form part of an investment portfolio.

1.3 THE ROLES OF FINANCIAL MARKETS IN THE

ECONOMY
We stated earlier that real assets determine the wealth of an economy, while financial assets
merely represent claims on real assets. Nevertheless, financial assets and the markets in which
they trade play several crucial roles in developed economies. Financial assets allow us to make
the most of the economy's real assets.

CAPITAL ALLOCATION
In a capitalist system, financial markets play a central role in the allocation of capital resources.
Investors in the stock market ultimately decide which companies will live and which will die.
If a corporation seems to have good prospects for future profitability, investors will bid up its
stock price. The company's management will find it easy to issue new shares or borrow funds to
finance research and development, build new production facilities and expand its operations.
If, on the other hand, a company's prospects seem poor, investors will bid down its stock price.
The company will have to downsize and may eventually disappear.
The process by which capital is allocated through the stock market sometimes seems
wasteful. Some companies can be 'hot' for a short period of time, attract a large flow of investor
capital and then fail after only a few years. But that is an unavoidable aspect of economic
uncertainty. It is impossible to predict with absolute precision which ventures will succeed and
which will fail. The stock market encourages allocation of capital to those firms that appear
at the time to have the best prospects. Many smart, well-trained and well-paid professionals
analyse the prospects of firms whose shares trade on the stock market. Share prices reflect their
collective judgement.

CONSUMPTION TIMING
In high-earnings periods you can invest your savings in financial assets such as shares and
bonds. In low-earnings periods you can sell these assets to provide funds for your consumption
needs. By so doing you can 'shift' your consumption over the course of your lifetime, thereby
allocating your consumption to periods that provide the greatest satisfaction. Thus, financial
markets allow individuals to separate decisions concerning current consumption from
constraints that otherwise would be imposed by current earnings.

ALLOCATION OF RISK
Virtually all real assets involve some risk. For example, when Toyota builds its auto plants it
cannot be certain what cash flows those plants will generate. Financial markets and the diverse
financial instruments traded in those markets allow investors with the greatest taste for risk
18 Principles of Investments

8 I PART l I Elements of investments

to bear that risk, while other less risk-tolerant individuals can, to a greater extent, stay on the
sidelines. If Toyota raises the funds to build its auto plant by selling both shares and bonds to
the public, the more optimistic or risk-tolerant investors can buy shares of stock in Toyota,
while the more conservative ones can buy Toyota bonds. Because the bonds promise to provide
a fixed payment the shareholders bear most of the business risk but reap potentially higher
rewards. Thus, capital markets allow the risk that is inherent to all investments to be borne by
the investors most willing to bear that risk.
This allocation of risk also benefits the firms that need to raise capital to finance their
investments. When investors are able to select security types with the risk-return characteristics
that best suit their preferences, each security can be sold for the best possible price. This
facilitates the process of building the economy's stock of real assets.

SEPARATION OF OWNERSHIP AND MANAGEMENT

AGENCY PROBLEMS
conflicts of interest
between managers and
shareholders
Many businesses are owned and managed by the same individual. This simple organisation is
well suited to small businesses. Today, however, with global markets and large-scale production,
the size and capital requirements of firms have skyrocketed. For example, in 2011 Telstra listed
$21.79 billion of property, plant and equipment and total assets of $37.91 billion on its balance
sheet. Corporations of such size simply cannot exist as owner-operated firms. At that time,
Telstra had 12.44 billion issued shares held by 1.3 million shareholders, of which 1.19 million
shares are held by small shareholders holding a parcel of less than 5000 shares.
Such a large group of individuals obviously cannot actively participate in the day-to-day
management of the firm. Instead, they elect a board of directors that in turn hires and supervises
the management of the firm. This structure means that the owners and managers of the firm are
different parties. This gives the firm a stability that the owner-managed firm cannot achieve.
For example, if some shareholders decide they no longer wish to hold shares in the firm, they
can sell their shares to other investors, with no impact on the management of the firm. Thus,
financial assets and the ability to buy and sell those assets in the financial markets allow for easy
separation of ownership and control.
How can all the disparate owners of a firm, ranging from large pension funds holding
hundreds of thousands of shares to small investors who may hold only a single share, agree on
the objectives of the firm? Again, the financial markets provide some guidance. All may agree
that the firm's management should pursue strategies that enhance the value of their shares.
Such policies will make all shareholders wealthier and allow them all to better pursue their
personal goals, whatever those goals might be.
Do managers really attempt to maximise firm value? It is easy to see how they might be
tempted to engage in activities not in the best interest of shareholders. For example, they might
engage in empire building or avoid risky projects to protect their own jobs or may overconsume
luxuries such as corporate jets, reasoning that the cost of such perquisites is largely borne by the
shareholders. These potential conflicts of interest are called agency problems because managers,
who are hired as agents of the shareholders, may pursue their own interests instead.
Several mechanisms have evolved to mitigate potential agency problems. First, compensation
plans tie the income of managers to the success of the firm. A major part of the total
compensation of top executives is typically in the form of stock options, which means that the
managers will not do well unless the share price increases, benefiting shareholders. (Options
can create an incentive for managers to manipulate information to prop up a share price
temporarily, giving them a chance to cash out before the price returns to a level reflective of the
firm's true prospects.) Second, while boards of directors are sometimes portrayed as defenders
of top management they can, and in recent years increasingly do, force out management teams
 Principles of Investments, First Australian Edition 19

CHAPTER 1 I Investments: background and issues I 9

that are underperforming. Third, outsiders such as security analysts and large institutional
investors can publicly criticise poor performers, creating bad publicity for the managers and
making their lives uncomfortable. Finally, poor performers are subject to the threat of takeover.
If the board of directors is lax in monitoring management, unhappy shareholders in principle
can elect a different board. They can do this by launching a proxy contest in which they seek to
obtain enough proxies (i.e. rights to vote the shares of other shareholders) to take control of
the firm and vote in another board. However, this threat is usually minimal. Shareholders who
attempt such a fight have to use their own funds, while management can defend itself using
corporate coffers. Most proxy fights fail. The real takeover threat is from other firms. If one firm
observes another underperforming, it can acquire the underperforming business and replace
management with its own team. The share price should rise to reflect the prospects of improved
performance, which provides incentive for firms to engage in such takeover activity.

XSTRATA'S BID FOR POOR PERFORMING MIM HOLDINGS EXAMPLE 1.1

In 2002, the Australian miner MIM was seen by many as a potential t akeover target.
Despite the potential value in the company's coal reserves, the share price had been
languishing due to weak management and underperforming operation s. Recognising
this, Xstrata, a global mining company, launched a bid for MIM in November 2002 at
$ 1.25 per share. To gain control of the company Xstrata needed the bid to be approved
by half the MIM shareholders.
The CEO of MIM, Vince Gauci, resisted the offer. A large shareholder, Platinum
Asset Management, also resisted, maintaining the bid undervalued the company. Gauci
commissioned an independent valuation of the company to help defend against the Xstrata
bid. The valuation subsequently confirmed that the $1.25 bid undervalued the company
and a proxy war ensued.
To entice shareholders, Xstrata lifted the initial bid to $1.72. Despite the continued
resistance from Platinum and Gauci, the increased offer persuaded shareholders to accept
the bid and the takeover was approved.

1.4 THE INVESTMENT PROCESS

An investor's portfolio is simply his or her collection of investment assets. Once the portfolio is
established, it is updated or 'rebalanced' by selling existing securities and using the proceeds to
buy new securities, by investing additional funds to increase the overall size of the portfolio, or
by selling securities to decrease the size of the portfolio.
Investment assets can be categorised into broad asset classes, such as shares, bonds, real
estate, commodities and so on. Investors make two types of decisions in constructing their
portfolios. The asset allocation decision is the choice among these broad asset classes, while ASSET ALLOCATION
the security selection decision is the choice of which particular securities to hold within each allocation of an investment
asset class. portfolio across broad
'Top-down' portfolio construction starts with asset allocation. For example, an individual asset classes
who currently holds all of his/her money in a bank account would first decide what proportion SECURITY SELECTION
of the overall portfolio ought to be moved into shares, bonds and so on. In this way, the broad choice of specific
features of the portfolio are established. While the average annual return on the ordinary shares securities within each
of large Australian firms since the 1950s has been about 14o/o per annum, the average return on asset class
Australian Treasury notes has been around 6.5%. On the other hand, shares are far riskier, with
20 Principles of Investments

10 I PART l I Elements of investments

SECURITY ANALYSIS
analysis of the value of
securities
annual returns over the same period ranging as low as -40o/o and as high as 67%. In contrast,
Treasury note returns are effectively risk-free: you know what interest rate you will earn when
you buy the note. Therefore, the decision to allocate investments to the stock market or to the
money market, where Treasury notes are traded, will have great ramifications for both the risk
and the return of the portfolio. A top-down investor first makes this and other crucial asset
allocation decisions before turning to the decision of the particular securities to be held in each
asset class.
Security analysis involves the valuation of particular securities that might be included in the
portfolio. For example, an investor might ask whether BHP Billiton, Rio Tinto, Woolworths
or Wesfarmers are more attractively priced. Both bonds and shares must be evaluated for
investment attractiveness, but valuation is far more difficult for shares because a share's
performance is usually far more sensitive to the condition of the issuing firm.
In contrast to top-down portfolio management is the 'bottom-up' strategy. In this process,
the portfolio is constructed from the securities that seem attractively priced without as much
concern for the resultant asset allocation. Such a technique can result in unintended bets on
one or another sector of the economy. For example, it might tum out that the portfolio ends up
with a very heavy representation of firms in one industry, from one part of the country, or with
exposure to one source of uncertainty. However, a bottom-up strategy does focus the portfolio
on the assets that seem to offer the most attractive investment opportunities.

Concept check 1.2
You are creating an investment portfolio and making a choice between different investments. Which
of the following are asset allocation decisions and which are security selection decisions?
a. Bonds or equities
b. Real estate or commodities
c. BHP Billiton or Rio Tinto shares

1.5 THE MAIN PARTICIPANTS

From a bird's-eye view, there would appear to be three major players in the financial markets:

1. Firms are net borrowers. They raise capital now to pay for investments in plant and
equipment. The income generated by those real assets provides the returns to investors
who purchase the securities issued by the firm.
2. Households are net savers. They purchase the securities issued by firms that need to raise
funds.
3. Governments can be borrowers or lenders, depending on the relationship between tax
revenue and government expenditure. For a long time the Commonwealth Government
of Australia's fiscal expenditure exceeded tax revenue and it had to rely on borrowings to
finance the deficits. This meant the government had to issue securities (Treasury bonds) to
fund the deficit. Historically, the first Australian public bonds were issued in 1915 to fund
the World War I effort in the form of War Savings Certificates. These were issued during
both world wars and were purchased mainly by the public and retail investors. 1 Issues of
Treasury bonds continued to fund budget deficits following the global recession of the
early 1990s. By 2006, government debt was reduced to zero following years of economic
growth and budget surpluses. However, by 2008-09 the Commonwealth had to resort
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 FACTORS INFLUENCING DIGESTION
As before stated, it is not the food eaten, but that which the body
digests and assimilates, or appropriates to its needs, which counts;
many factors influence such nourishment. The principal ones are the
forceful circulation, the breathing of plenty of oxygen, and the
resultant free elimination of waste.

If one has no appetite, by far the safest method

The Appetite is to abstain from food until the system calls for it,
or to eat but a very little of the lightest food at
regular meal times; be careful not to mince between meals nor to eat
candy nor pickles. Be sure that the lack of appetite is not due to
mental preoccupation which does not let the brain relax long enough
for the physical needs to assert themselves. One should relax the
brain in pleasant thoughts during a meal.
If the appetite is lacking, because of physical exhaustion, it is
unwise to eat, because the digestive organs are tired, and to load a
tired stomach with food, still further weakens it and results in
indigestion. The better plan is to drink two glasses of cold water and
lie down for an hour; if there is still no desire for food, drink freely of
water, but abstain from food until hungry.
This should not lead one into forming the habit of irregular eating,
however. The stomach forms habits and the supply of food must be
regular, just as the nursing child must be fed regularly, or digestive
disturbance is sure to result.
A wise provision of Nature makes the system, in a normal
condition, its own regulator, protesting against food when it has not
assimilated or eliminated that consumed. One should learn to obey
such protests and cut down the quantity when Nature calls “enough.”
There are exceptions, however. Some phases of indigestion result
in a gnawing sensation in the stomach, which is often mistaken for a
desire for food. This is not a normal appetite. Water will usually
relieve it.
Often loss of appetite is the result of a clogging of intestines or
liver, or to an excess of bile, which, not having been properly
discharged into the intestines, has entered the blood stream. An
excess of bile and poisons, indicating a torpid liver, often expresses
itself in a dull mental force, the toxins deadening the nerve cells.
Nature does not call for more food until she has eliminated the
excess of waste.
It is commonly stated that the body will call for what the system
requires. This may have been true of the aborigines, who ate their
food in its natural state, and, to a certain extent, it is true to-day, but
condiments and stimulants, to make the food “appetizing,” have
unduly stimulated the nerves and perverted the natural taste; foods
containing their natural amount of spices or extractives no longer
tempt one. Those whose nerves are highly keyed, form the habit of
seasoning the food too strongly, making it too stimulating. This
undue stimulant calls for more food at the time of eating than a
normal appetite would demand. The taste being cultivated for the
stimulant, the habit of eating too much food is formed.
There is a difference between the cultivated and the normal
appetite. A child rarely shows a desire for stimulants or condiments,
unless unwisely encouraged by an adult, who does it,—not because
it is good for the child, but because the individual himself has
cultivated a taste for it. It is as easy to form healthful tastes and
habits of eating as unhealthful ones, and care should especially be
exercised in the formation of healthful habits by the growing child.
The simple foods, in their natural state, are in the right condition to
be digested, with the aid of heat to break the cellular coverings of the
globules of some of them, but time, energy, muscular activity, nerve
force, and money are spent in combining, seasoning, and cooking
foods in such a manner as often to render them difficult of digestion.
Deep breathing of fresh air, to throw off the poisonous carbon
dioxid and to supply an abundance of oxygen to oxidize the waste,
thus putting it in condition to be expelled from the system; brisk
exercise to accelerate the circulation, that the blood may carry the
oxygen freely and that the tissues may liberate the carbon dioxid and
other waste; and a copious drinking of water, are the best tonics for
loss of appetite or for a lack of vitality.

It is economy, therefore, to keep the digestive

Economy in organs and the circulation and tissues strong, in
Food order that all foods eaten may yield returns,
instead of hampering activity.
The food which furnishes the most tissue-building substance and
yields the most heat and energy, with the least refuse, is the
economical food. In the selection of food for any individual, the result
to be gained from the food must be borne in mind. If one is doing
heavy muscular work, more protein to rebuild tissue, as well as more
carbohydrates and fats to produce energy, are required than if one’s
habits of work are sedentary. In mental work, where the brain is
continually active, proteins are required to re-supply the brain tissue,
but the fats and carbohydrates may be lessened. This would seem to
contradict the theory that where one’s habits are sedentary and the
brain alone is active, the proteins are not required. In sedentary
occupation, the carbohydrates and fats are stored within the system,
clogging it and producing torpid liver, constipation, and obesity,—
unless the brain is sufficiently active to use all of the fuel in brain
energy.
In a dietary study of the following tables, the question should be to
provide the largest quantity of nutriment at the lowest cost, with due
attention to palatability and variety. In the selection of meats, for
instances, while beefsteak may cost twice as much as beef stew, it
must be borne in mind that beefsteak contains very little waste, and
it contains a large proportion of albuminoids, or the tissue building
proteins, while, in the beef stew, the bones and the connective tissue
predominate; the proteins yielded from the beef stew are a large
proportion gelatinoids and extractives,—not the tissue building
albuminoids. This would not hold in comparing the cheaper and the
more expensive cuts in the same kind of beefsteak; the cheaper cuts
often yield quite as much nutriment as the more expensive ones.
Round steak is just as nourishing as porter-house and much
cheaper.
Much is said about the bacteria present in the atmosphere, the
microbes in the food, etc., that one is puzzled to know, not only what
to eat, but how to breathe, and, in fact, which way to turn to avoid
them; but microbes and bacteria have been present in the
atmosphere and in matter everywhere since time began. They are a
part of the natural surroundings, and the body, if kept in strong
vitality, has sufficient resistive power to enable one to live unharmed
by them. The danger lies in allowing the system to run down and the
vital force to ebb, so that the body becomes an easy prey to them.

There is no doubt but that the habit of eating

Habit and governs one’s convictions of what the system
Regularity of requires. One is inclined to think that a desire for a
Eating. food is a requirement of Nature; yet it may simply
be the continuance of a habit. The vital organs
form habits just as one forms a habit of walking, sitting or of carrying
the head or the hands, and habit re-asserts itself.
If a mother feeds her babe every three hours the child will usually
wake and call for food about this period. If she has formed the habit
of nursing the child every two hours, it will call for food in about two
hours, even though all symptoms indicate that the child is over fed.
It is important that both child and adult establish regular and
hygienic habits because the digestive juices secrete themselves at
the regular periods established. A right habit is as easily formed, and
as difficult to change, as a wrong one.
If one forms the habit of eating a certain amount of food, the
stomach calls for about the same amount, and when one first begins
to change the quantity it protests, whether the change be to eat more
or less.
Few people form the habit of drinking sufficient water,—particularly
if they have been taught that water at meals is injurious. In this busy
life, few remember to stop work and drink water between meals, and
if not consumed at the meal time the system suffers. Many people
look “dried up.”
The habit of drinking two glasses of water upon first arising, and
six more during the day is an important one.

There is no doubt but that a large number of

Frequency of people overload the digestive organs. This, as well
Meals as the bolting of food, insufficiently masticated,
cannot be too strongly denounced. All food should
be chewed to a pulp before swallowed.
As a relief from overeating, many theorists are advocating two
meals a day, but the work of the average man is planned into
morning and afternoon sessions, and the three meals have been
arranged accordingly.
Where two meals a day are eaten, the first meal should be at nine
or ten o’clock in the morning and the second meal at five or six
o’clock in the afternoon; whereas, for the average person who eats
two meals a day, the custom is to go without food until the midday
meal, and then to eat two meals within six hours, with nothing more
for eighteen hours.
The argument in favor of two meals a day has been that the
digestive system is inactive during sleep, and, therefore, the system
is not ready for a meal upon arising, but the latest experiments
(Pawlow) show that digestion continues during sleep, though less
actively. It must be borne in mind that the average evening meal is
eaten about six o’clock and that there are about four waking hours
between this meal and the sleep period; also, that the average
individual is awake and moderately active an hour before the
morning meal. This gives five waking hours between the evening
and the morning meal. About the same time, five hours, elapses
between the morning and the midday meal, and between the midday
and the evening meal, so that three meals a day divide the digestion
periods about evenly.
More frequent meals, served in lighter quantity, with greater
regularity, so that the system is not overloaded at any one meals, is
rational for delicate, or undernourished nerves and tissues. The little
child is fed regularly every three hours.

Daily exercise and the habit of full breathing are

Effect of absolutely necessary that the waste of the system
Exercise and may be fully liberated, that the nourishment may
Breathing upon be carried freely to every tissue, and that sufficient
Digestion
oxygen may be carried through the blood to
oxidize the waste, or, to put it into condition to be
thrown off.
The necessity of oxygen as food is evident. The body will subsist
about forty days upon the food stored within it, without re-supply, but
it can endure only a few seconds without oxygen, because heat,
occasioned by the union of oxygen with carbon and hydrogen, is
necessary to keep up the physical activity termed “life.” The
necessity of habits of full, correct breathing cannot be too fully
emphasized. The quantity of oxygen, daily consumed, should fully
equal the sum of all other food elements.[6]
Oxygen is necessary to cause combustion of fats, starches and
sugars, just as it is necessary to cause combustion of carbon in
wood, or coal.
 The heat from “burning” wood is produced by the oxygen of the air
uniting with hydrogen and carbon, forming carbon-dioxid (carbonic
acid gas) and water.
The light in the burning of wood is caused by the rapid combustion
of the carbonic acid gas. The same combustion occurs within the
body continuously, though more slowly, hence no light is produced.
The carbon in the body is liberated and brought into contact with
more oxygen in the blood through exercise and full breathing, just as
a fire is fanned to flame by bringing more oxygen into contact with
the fire, by means of a draught of air. Keep all air away from a fire
and it “goes out,” or ceases to unite with the oxygen, and no heat is
produced; keep all air from within the body, by cessation of
breathing, and it also becomes cold. A room in which the air is
impure, containing insufficient oxygen, is heated with difficulty,—the
body which is not constantly supplied with pure air generates very
little body heat. The effect of oxygen in the creation of heat is
practically demonstrated by repeatedly filling the lungs with air while
out in the cold. The body will become quickly warmed on the coldest
day by this practice.
Deep breathing aids digestion and assimilation, not alone because
of the regular exercise given to the pancreas, the spleen, the
stomach, and the liver by the correct movement of the diaphragm,
but because of the latent heat which the oxygen liberates within the
digestive organs and out among the tissues.
While the chemical action of food creates activity within, this
activity is materially aided by exercise, and oxygen is imperative, as
shown above. Exercise and oxygen are also necessary for chemical
action in tearing down waste and in putting raw material into
condition to be appropriated to the body needs.
Two glasses of water in the morning and fifteen minutes’ brisk
exercise of well selected movements, to start a forceful circulation
and to surge the water through the vital organs, are a daily necessity
if one is to keep clean and strong within. It is as important to cleanse
the body within as without. It is the method employed by all men and
women who would retain strong vital forces to a ripe old age. They
fully enjoy the mere living.

Since the condition of the body so materially

“Tired” or affects the digestion, absorption, and metabolism
Disturbed of food, as well as the elimination of waste, it is not
Balance amiss to discuss it here.
The habit of eating when too tired and then at once going to work,
so that the blood is called from the stomach, is almost sure to result
in indigestion.
The average person is tired because the brain and nerves are
more active than the muscles and is rested by muscular exercise, or
change of work.
The regular work of the body in keeping up the heart action and
the circulation and in renewing and relieving waste, requires a
certain quantity of oxygen to liberate energy. This energy the system,
in normal condition, with normal breathing, readily furnishes, but
when that used in undue muscular work is more than that being
liberated at the time, through combustion, the energy required for the
constant bodily needs is called upon, and the muscles, nerves and
tissues are then in the state termed “tired.” They remain so until
sufficient oxygen has liberated more potential energy than is needed
for the work constantly going on in the body. When a sufficient
supply of oxygen has been consumed to equal the demand, the
body is in a state of rest.
In mental work the nerves and the brain call for the surplus energy,
while in muscular work the tissues require it, hence undue work,
either mental or physical, expresses itself in bodily fatigue, until the
oxygen equals the demand in all parts of the body.
A torpid condition of body, producing inertness, means that the
waste of the system is not relieved. It may be that by reason of
insufficient breathing of pure air, sufficient oxygen is not consumed
to put the waste in condition to be eliminated. This poisonous carbon
dioxid being hoarded, dulls the nerve sensation and the brain action
and produces more or less of stupor. It may be because the
circulation in some part of the body is clogged (most often the portal
circulation through the liver), so that sufficient oxygen is not carried
to that part.
Relief from this “inertness” is experienced most quickly by exercise
in the fresh air, that the circulation may be quickened and the oxygen
more freely carried to each part. Exercise in one’s room by the open
window, or at least with the air in the room pure, is often preferable
to outdoor exercise, because the body can be nude, or so loosely
clothed that the oxygen may not only enter the lungs but also
circulate about the pores of the skin. Fifteen minutes of brisk
exercise in one’s room is better than a five-mile walk, because if the
exercises be intelligently selected, every organ and tissue is used,
while walking exercises only about one-fourth of the muscles. If the
circulation is clogged, the exercising must be kept up persistently,
until the obstruction is removed and particular attention must be
given to the supply of fresh air in the room.
After sleeping in a room with impure air, one arises fatigued,
because of insufficient oxygen to liberate the energy required for
circulation and catabolism, and because the carbonic acid gas
cannot be relieved without oxygen to cause combustion. As stated
above, if the poisonous carbonic acid gas remains in the system, it
deadens the nerve sensation and produces a semi-stupor.
The relief, then, from the state of body we call “tired,” is in the
distribution of the circulation, calling the blood from the unduly
distended capillaries, and supplying the normal quantity of oxygen.
Rightly directed physical exercise renews the circulation to all parts,
incites deep breathing, and puts the body in the state of harmony
called “rest.”
Harmony, either mental or physical, is rest.
With a little more intelligence in keeping up the supply and
demand of oxygen, in establishing correct breathing habits, and in
understanding the law of distribution of circulation, which means the
harmony of forces, this tired world could draw a deep, restful breath.

The state of the mind has much to do in

Influence of the regulating the digestive system. Cheerful thoughts
Mind put the nerves of the entire organism in a natural
state, while disagreeable thoughts put the nerves
in a tense, unnatural condition. The nerves to the digestive system
are affected by the tensity of the mind, just as the nerves to any
other part of the body. As an illustration of this;—if one thinks ugly,
disagreeable thoughts for a continuous period, actual illness results.
These thoughts affect the digestion in such a manner that the
appetite sometimes entirely wanes. All so-called “new thoughts,”
“ologies,” or “isms,” conducive to the formation of the habit of looking
upon the bright side of life, or of looking for good and joy in life, put
the nerves in a natural state, affecting the digestion and
consequently the health. The practice is Christian Sense.
The nerves control, to a great degree, the peristaltic movements of
the stomach and the action of the absorption cells, as well as the
cells which secrete the digestive juices. Thus it is that a food which
one likes is not only more palatable, but it will digest more readily,
because the digestive juices flow more freely.
It is well, therefore, to begin the meal with something which tastes
particularly good, that the flow of these digestive juices may be
incited. For this reason, if one cares for fruit, it is an excellent custom
to begin the meal with fruit, or with soup, containing protein
extractives, which stimulate the flow of digestive juices. The habit of
finishing a meal with some tasty dessert, is based upon the scientific
principle that by so doing the gastric juices will flow more freely after
the meal, thus aiding in its digestion.
Dainty service in a sick-room, because of the psychic effect of a
meal daintily served, is of utmost importance. Because of the effect
upon the mind the sight of a meal served upon soiled linen will
almost stop the flow of gastric juice and destroy the desire for food,
while a meal daintily served upon dainty linen, with garnishings and
tasteful table decorations, incites the flow of gastric juices.
The careful wife and mother, who notes the appetites of members
of her family failing, should attend carefully to the garnishing of her
dishes and to serving them in a neat, attractive manner; also to
changing her table decorations, as far as may be consistent, so that
the eye as well as the sense of smell and taste may be pleased.
It is strange, but it is true, that just a fresh flower, or a new table
decoration, may so put the mind of one who is afflicted with nervous
indigestion in a receptive state that the meal more readily digests,
while an untidy table, or a lot of food served untidily would retard
digestion. One may be able to control the thoughts under most
circumstances but the above is a physiological fact.
Sometimes the sight of quantities of food turns one against it. The
custom among hearty eaters, of serving a plate too plentifully,
destroys the appetite of one whose digestion is not so hearty.
Our grandmothers’ overloaded tables, with sufficient food of
various kinds to serve many times the number of participants, might
stimulate the appetite of hearty, strong men, while the very sight of
so much might turn the appetite of one more delicate, whose system
did not crave food.

FOOTNOTES:
[6] Editor’s Note.—Measurements of eighteen thousand women
show that sixty-two per cent of women use only about one-half of
their lung capacity and less than nine per cent use their full
capacity.
 CLASSIFICATION OF FOODS
In the previous chapters, we have given the classification of the
elements in foods which supply the body needs. Below we classify
the foods commonly used, according to the predominance of these
elements.
Carbonaceous Foods
While all foods contain a combination of elements, the foods
described below contain a greater proportion of carbohydrates and
fats, and are classed as carbonaceous.

Of the carbohydrates, next in importance to the

Roots and sugars and to the starches in their purest form
Tubers (corn starch, tapioca, sago, and arrowroot), come
the roots and tubers, such as potatoes, sweet
potatoes, beets, parsnips, turnips and onions.
The following table shows the proportion of various foodstuffs in
these vegetables:
TABLE I—ROOTS AND TUBERS
Water Fat Ash
Protein Carbohydrates Food Value per
Food Materials Per Per Per
Per Cent Per Cent pound Calories
Cent Cent Cent
Sweet Potatoes 69.4 1.5 0.3 26.2 2.6 440
White Potatoes 75.0 2.1 0.2 22.0 0.7 295
Parsnips 64.4 1.3 0.4 10.8 1.1 230
Onions 86.0 1.9 0.1 11.3 0.7 225
Beets 87.0 1.4 0.1 7.3 0.7 160
Carrots 88.2 1.1 0.4 8.2 6.0 210
Turnips 92.7 0.9 0.1 0.1 0.6 120
 Potatoes. It will be noted from the above table that sweet potatoes
have a larger percentage of carbohydrates, hence they produce
more heat and energy, than any other vegetable; next to the sweet
potato, the Irish potato.
In the above table, the skins of the vegetables are included, and
while the white potato contains two per cent protein, this is almost all
located in a very thin layer immediately beneath the skin, so that
when the potato is peeled in the ordinary way, the protein is
removed. This holds true in many vegetables. They lose their
distinctive flavor, as well as their value as tissue building foods, when
the skins are removed. In baking a potato, the outer skin is readily
separated from a less perceptible covering containing the protein,
and this second skin should be eaten to get the full value and flavor.
In the white potato, of the twenty-two per cent carbohydrates three
and two-tenths per cent is sugar and eighteen and eight-tenths per
cent is starch. In the sweet potato, ten and two-tenths per cent is
sugar and sixteen per cent is starch. Since sugar digests more
quickly than starch, the sweet potato digests more quickly than the
white. Because of the large per cent or carbohydrates in each, it is a
mistake to serve these two vegetables at the same meal. For the
same reason, bread and potatoes should not be eaten, to any
extent, at the same meal, unless by one who is doing heavy manual
labor, requiring much energy.

Onions. Only about four per cent of the onion represents

nourishment; the eleven per cent of carbohydrates is made up of two
and eight-tenths per cent sugar and the rest extractives. Of the
extractives the volatile oil, which causes the eyes to water when
peeling, is the most important. The onion is not, therefore, so
important for its actual nourishing qualities as for its relish and flavor,
and for this it is to be commended. It is a diuretic, encouraging a free
action of the kidneys. Because of its diuretic value it is commonly
called a healthy food. An onion and lettuce sandwich stimulates the
action of the kidneys and is a nerve sedative.
The volatile oil makes the onion difficult for some to digest and, in
that case, should be omitted from the diet.

Beets. There is no starch in beets, the seven and three-tenths per

cent carbohydrates being sugar; they possess, therefore, more
nutritive value than onions, and they are easily digested. It will be
noted that it takes many beets to make a pound of sugar.
There are no more delicious nor nutritive greens than the stem
and leaf of the beet. These greens contain much iron and are
valuable aids in building up the iron in the blood, thus correcting
anaemia.

Carrots. Carrots are valuable as food chiefly on account of their

sugar. They are somewhat more difficult of digestion than beets and
they contain more waste. They make a good side dish, boiled and
served with butter or cream.

Turnips. Turnips have little value as a food. Their nutriment

consists in the sugar they contain. For those who enjoy the flavor
they are a relish, serving as an appetizer, and, like the onion, are to
be recommended as a side dish for this purpose.

Parsnips. Like carrots, parsnips are chiefly valuable for their

sugar and for the extractives which act as appetizers.
 Since turnips, carrots, onions, and parsnips owe a part of their
value in nutrition to the extractives which whet the appetite for other
foods, it follows that, if one does not enjoy the flavor or the odor,
these vegetables lose in value to that individual as a food. If one
does enjoy the flavor, it adds to their food value.

The question may be asked with reason: “Why

Green do we eat green vegetables?” They contain only
Vegetables about four per cent nutrition, as will be seen by the
chemical analysis in the following table, and are
mostly made up of water and pulp. It will be noted from the table that
they are distinctly lacking in protein (nitrogenous matter) and in
carbohydrates; hence, they have little food value. Some of them
have strong acids, thus increasing the alkalinity of the blood.
Their merit lies in the fact that they have distinct flavors and thus
whet the appetite. Another reason why green vegetables are
thoroughly enjoyed is because they come fresh in the spring, when
the appetite is a little surfeited with the winter foods and one looks
for green things.
TABLE II—GREEN VEGETABLES
Fuel
Mineral
Water Nitrogenous Fat Value
Carbohydrates Matter Cellulose
Food Materials per Matter per per per
per cent per per cent
cent cent cent pound
cent
Calories
Cabbage 89.6 1.80 0.4 5.8 1.3 1.1 165
Spinach 90.6 2.50 0.5 3.8 1.7 0.9 120
Vegetable
94.8 0.06 0.2 2.6 0.5 1.3 120
Marrow
Tomatoes 91.9 1.30 0.2 5.0 0.7 1.1 105
Lettuce 94.1 1.40 0.4 2.6 1.0 0.5 105
Celery 93.4 1.40 0.1 3.8 0.9 0.9 85
Rhubarb 94.6 0.70 0.7 2.3 0.6 1.1 105
Water Cress 93.1 0.70 0.5 8.7 1.3 0.1 110
Cucumbers 95.9 0.80 0.1 2.1 0.4 0.5 10
Asparagus 91.7 2.20 0.2 2.9 0.9 2.1 110
Brussels
93.7 1.50 0.1 3.4 1.3 0.4 95
Sprouts
Beans (string) 8.92 2.3 0.3 7.4 0.8 7.0 195
Beans (dried) 12.6 22.5 1.8 59.6 3.5 0.0 1605
Peas (green,
74.6 7.0 0.5 16.9 1.0 0.0 465
shelled)

All fresh vegetables should be masticated to almost a fluid

consistency; otherwise, they are difficult of digestion, containing, as
they do, so much pulp.
They are diuretic, helping the kidneys and the skin to rid the
system of waste, and they are more laxative to the intestines than
the root vegetables, partly because of the salts which they contain
and partly because of the undigested vegetable fibre, which helps to
move along the waste in the intestines. This vegetable fibre, being
coarse, assists in cleansing the mucous lining of stomach and
intestines, and, if for no other reason than for this cleansing of
kidneys and intestines in the spring, when the system is most
sluggish, the use of green vegetables is to be commended.
In larger cities, fresh vegetables are in the markets the year
around, but if they are raised in greenhouses, or in any way forced,
they lack the matured flavor and they also lack the iron which the
rays of the sun give. If raised in the south and shipped for a distance,
they are not fresh and they do not have as good an effect upon the
system as when fresh and fully matured by the sun.
All greens, as spinach, chard, dandelions and beet tops, as
previously stated, contain iron and build red blood corpuscles.
It is well, then, to eat freely of fresh vegetables in their season,
even though they do not appreciably build tissue or furnish energy.
By their effect upon the blood, the kidneys, skin, and intestines, they
make sluggish vital organs more efficient.
Tomatoes and rhubarb are often, and with reason, classed under
fruits.
 Technically speaking, fruits include all plant
Fruits products which bear or contain a seed. They are
valuable for their acids and organic salts—citrates,
malates, or tartrates of potassium, sodium, magnesium, and calcium.
In the juices of citrous fruits, are citrates of above minerals.
The fruit juices are readily absorbed and carried at once to the
liver, where the sodium, magnesium, and potassium are released
and the acids oxidized and changed to carbonates. They increase
the alkalinity of the blood. These alkalis are soon eliminated through
the kidneys, which accounts for the diuretic effect of fruits.
The seeds in the small fruits are not digested, but they serve the
purpose of increasing intestinal peristalsis and of assisting the
movement of the contents of the intestines. The skin and the fibre of
fruits also assist the intestines in this way, just as the fibre in
vegetables does. Fruits may be classified into acid and sweet fruits.
Under acid fruits are the citrous group—lemons, limes, grape fruit,
oranges, cranberries, gooseberries, whortleberries, pineapples,
currants, and rhubarb—if rhubarb is to be classed as a fruit.
There has been a commonly accepted theory that where a blood
test shows evidence of too much uric acid, acid fruits are to be
avoided, but the reverse is true. It has been fully demonstrated that
the use of acid fruits increases the alkalinity,—or neutralizes the
acids in the blood.
In case of an excess of hydrochloric acid in the stomach, lemon, or
citrous fruits are valuable about half an hour before a meal as they
decrease the secretion of the hydrochloric acid into the stomach.
Where hydrochloric acid is limited, acids are given after a meal to
supplement the deficient amount.
The sweetening of acid fruits does not detract from the value of
the acids or of organic salts.
All acid fruits stimulate the action of the kidneys and the skin,—
particularly lemons, limes, grape fruit, and oranges, and wherever
the kidneys and skin are not sufficiently active, these fruits should be
eaten freely.
It is difficult to make a decided distinction between sweet and acid
fruits. The best guide is in the amount of sugar required to make
them palatable. Some species of cherry are distinctly sour, while
others are sweet. The same is true of apples, peaches, plums, etc.
Under sweet or bland fruits are pears, raspberries, grapes,
bananas, blackberries, blueberries, melons, apricots, and some
peaches, apples, and plums.
The large majority of fruits do not contain sufficient sugar to make
them valuable for nourishment. Their chief value is in their appetizing
flavor, and in the acids, and salts. Dates, figs, prunes, and dried
grapes (raisins) are exceptions. As will be noted by the following
table, these fruits contain a large amount of carbohydrates in the
form of sugar. The larger amount of protein in these sweet fruits is
largely in the seeds and, as the seeds are not digested, they have no
real food value to the individual.
Figs and prunes are laxative,—probably the laxative effect of figs
is due to the seeds, and of prunes to the salts and acids. However,
prunes are free from tannic acid.
TABLE III—FRUITS
Water Protein Ether Ash Acids
Carbohydrates Cellulose
Food Materials Per Per Extract Per Per
Per Cent Per Cent
Cent Cent Per Cent Cent Cent
Acid:
Apples 82.50 0.40 0.5 12.5 0.4 2.7 1.0
Apricots 85.00 1.10 0.6 12.4 0.5 3.1 1.0
Peaches 88.80 0.50 0.2 5.8 0.6 3.4 0.7
Plums 78.40 1.00 0.2 14.8 0.5 4.3 1.0
Cherries 84.00 0.80 0.8 10.0 0.6 3.8 1.0
Gooseberries 86.00 0.40 0.8 8.9 0.5 2.7 1.5
Currants 85.20 0.40 0.8 7.9 0.5 4.6 1.4
Strawberries 89.10 1.00 0.5 6.3 0.7 2.2 1.0
Whortleberries 76.30 0.70 3.0 5.8 0.4 12.2 1.6
Cranberries 86.50 0.50 0.7 3.9 0.2 6.2 2.2
 Oranges 86.70 0.90 0.6 8.7 0.6 1.5 1.8
Lemons 89.30 1.00 0.9 8.3 0.5 1.5 1.8
Pineapples 89.30 0.04 0.3 9.7 0.3 1.5 7.0
Pears 83.90 0.40 0.6 11.5 0.4 3.1 0.1
Blackberries 88.90 0.90 2.1 2.3 0.6 5.2 1.6
Raspberries 84.40 1.00 2.1 5.2 0.6 7.4 1.4
Mulberries 84.70 0.30 0.7 11.4 0.6 0.9 1.8
Grapes 79.00 1.00 1.0 15.5 0.5 2.5 0.5
Watermelons 92.90 0.30 0.1 6.5 0.2 1.0 0.5
Bananas 74.00 1.50 0.7 22.9 0.9 0.2 0.5
Sweet:
Dates, dried 2.08 4.40 2.1 65.1 1.5 5.5 7.0
Figs, dried 2.00 5.50 0.9 62.8 2.3 7.3 1.2
Prunes, dried 2.64 2.40 0.8 66.2 1.5 7.3 2.7
Raisins 10.60 2.50 4.7 74.7 3.1 1.7 2.7

Care should be exercised in selecting ripe fruits and those which

have not started to decay. The difficulty with so many fruits, which
must be shipped from a distance, is, that, in order to reach their
destination in fair condition, outwardly, they are picked before ripe
and there is too much tannic acid in them. When fruits are allowed to
ripen on the trees, the tannic acid is changed to sugar and fruit
juices. One test of a ripened apple is to cut it with a steel knife—if the
blade turns black, or if the cut surface of the apple turns brown in a
few minutes, it should not be eaten, for it indicates an excess of
tannin. It is this tannin which gives the small boy, with his green
apples, excruciating pains. It will be recalled that the tannin from the
bark of trees, so toughens the elastic skin of animals that we can
wear this skin for shoes. The effect upon the live skin of the stomach
and intestines, from the tannin in food, is not pronounced in
toughening the skin, because of the activity and resistance of live
matter.
Bananas are commonly picked green, because they decay so
quickly that if they were picked ripe they would spoil before reaching
the northern markets. The above table shows that bananas contain
nearly twenty-three per cent of carbohydrates, which, in an immature
state, are largely starches. The natural ripening process changes the
starch to sugar, thus making them more easily digested. The starch
globules, when not matured on the tree, are not easily broken and
are thus difficult of digestion. Baking breaks the globules; a baked
banana is thus more readily digested.