Fundamentals of InvestingFundamentals of Investing Lawrence J. Gitman San Diego State University Michael D. Joehnk Arizona State University Published for LOMA Education and Training Programs Information in this text may have been changed or updated since its publication date. For current updates, visit www.loma.org ° Information That Works Boston San Francisco New York London Toronto Sydney Tokyo Singapore Madrid Mexico City Munich Paris Cape Town Hong Kong MontrealCover art by Kathleen Ryan, FLMI, PCS, AIRC, AIA, ARA, PAHM. Taken from Funtanentals of cesting, Bighth Edition bby Lawrence J. Gitman and Michael D. Jochnk Copyright © 2002 by Lawrence J. Gitman and Michael D. Joehnk Published by Addison Wesley, Inc 'APearson Education Company Boston, Massachusetts 02116 For permission to use copyrighted material, grateful acknowledgment is made to the copytight holders on pp. C-1-C-2, which are hereby made part ofthis copyright page. LOMA Edition Copyright © 2004 ‘This special edition published in cooperation with Pearson Custom Publishing, All eights reserved. No part of this book may be reproduced, stored in a retrieval systein, or transmitted, in any form for by any means, electeonic, mechanical, photocopying, recording, of otherwise, without the prior written permission {rom the publisher. For information on obtaining permission for use of material from this work, please submit a written zequest to Pearson Education, Inc. kights and Contracts Department, 75 Arlington Street, Suite 390, Boston MA C2116, os fax your request to (617) 843-7087, Please Visit ous web site at xuunpearsonted com ISBN 0-536-75427-6 BA 999228 Ic Printed in the United States of America 23.45 07 06BRIEF CONTENTS Detailed Contents Foreword xiii Preface xv PART one THE INVESTMENT ENVIRONMENT 1 1 The Role and Scope of Investments 2 2 Investment Markets and Transactions 30 3 Investment Information and Trading 60 Part two IMPORTANT CONCEPTUAL TOOLS 99 4° Investment Return and Risk 100 3 Modern Portfolio Concepts 133 Paat tTHree INVESTING IN COMMON STOCK 165 6 Common Stock Investments 166 7 Analytical Dimensions of Stock Selection 207 8 Stock Valuation and investment Decisivas 240 pPaRT FOUR INVESTING IN FIXED-INCOME SECURITIES 285 9 Bond Investments 286 10 Bond Valuation and Analysis 321 Part Five PORTFOLIO MANAGEMENT 353 11 Mutual Funds: Professionally Managed Investment Portfolios 354 Appendix A Financial Tables A-I dts CH Glossary G1 Index 14CONTENTS Part onc THE INVESTMENT ENVIRONMENT 1 cHaPtTeR 1 THE ROLE AND SCOPE GF INVESTMENTS 2 TSORAVMA Opening Vignette 2 |] Test Your tnvestmentia ‘Investments and the Investment Process 3 | tessons fr Investment Types of Investments 3 / The Structure of the | Success 8 Investment Process. 5 Invesument Vehicles Nae Short-Term Vehicles 9 / Common Stock 9 / Fixed: Income Securities 10 / Mutual Funds 11 / Derivative Securities 11 / Other Popular Investment Vehicles 11 Making Invesiment Plans 12 ‘Steps in Investing 12 / Considering Personal Taxes 14 / Investing Over the Life Cycle 18 J Investing in Ditferent Economic Environments 19 Meeting Liquidity Needs: Investing in Short-Term Vehicles 21 ‘The Role of Short-Term Vehicles 21 / Popular Short-Term Investment Vehicles 22 / Investment Suitability 26 Summary 28 CHAPTER 2. INVESTMENT MARKETS AND TRANSACTIONS 30 TARR Opening Vignette 30 Riding the IPO Roller Securities Markets 31 Sooner 2 Types of Securities Markets 31 / Organized Securities Stock Around the Clock 4 Exchanges 36 / The Over-the-Counter Market 38 / Alternative Trading Systems 40 / General Marker . Conditions: Ball or Bear 41 Globalization of Securities Markets 41 Growing Importance of International Markets 41 / International Investment Performance 42 / Ways to Invest in Foreign Securities 43 / Risks of Investing Internationally 44CHAPTER 3 2 aa CHAPTER 4 Maybe Can You Handle? Many Happy Returns... 8 How Much Investment Risk 130 Trading Hours and Regulation of Securities Markets 45 Trading Hours of Securities Markets 45 7 Regulation of Securities Markets 47 Basic Types of Secucities Transactions 49 0 / Margin Trading 50 / Shore Long Purchase Selling 56 Summary 58 INVESTMENT INFORMATION AND TRADING 60 Opening Vignette 60 ‘Types and Sources of Investment Information 61 ‘Types of Information 61 / Sources of Informarion 63 Understanding Market Averages and Indexes 76 Stock Market Averages and Indexes 76 / Bond Market Indicators $2 Making Securities Transactions 83 The Role of Stockbrokers 83 / Basic Types cf Orders 87 / Online Transactions 89 / Transaction Costs 95 / Investor Protection: SIPC and Arbitration 96 Summary 97 “s*"pany two IMPORTANT CONCEPTUAL TOOLS 99 INVESTMENT RETURN AND RISK 100 Opening Vignette 100 The Concept of Return 101 Components of Return 101 / Why Return Is Important 102 / Level of Return 103 The Time Value of Money 104 Interest: The Basic Return to Savers 106 / Computational Aids for Use in Time Vahue Calculations 108 / Future Value: An Extension of Compounding 109 / Future Vatue of an Annuity 110 / Present Value: An Extension of Future Value 111 / The Present Value of a Stream of Returns 112 / Determining a Satisfactory Investment 113CHAPTER 5 TN || Why Ventuce Abroad? — 142 University Portotia Managers Earn ar Ay 161 CHAPTER 6 ny Return 115 Risk-Free, and Required Returns 145 / Holding Period Return 116 / Yield: The Internal Rate of Return 118 / Finding Growch Ratey 121 Risk: The Other Side of the Coin 122 Sources of Risk 122 / Risk of a Single Asset 125 / Assessing Risk 128 / Steps in the Decision Process: Combining Return and Risk 131 Summary 131 MODERN PORTFOLIO CONCEPTS 133 Opening Vignerte 133 Principles of Portfolio Planning 134 Portfolio Objectives 134 / Portfolio Return and Standard Deviation 134 / Correlation and Diversification 136 / International Diversification 140 The Capital Asset Pricing Model (CAPM) 143 Components of Risk 143 / Beta: A Popular Measure of Risk 144 / The CAPM: Using Beta to Estimate Return 147 Tiaditional versus Modern Portfolio. 149 The ‘Traditional Approach 149 / Modern Portfolio Theory 150 / Reconciling the Traditional Approach and MPT 156 Constructing a Portfolio Using an Asset Allocation Scheme 157 Investor Characteristics and Objectives 157 / Portfolio Objectives and Policies 158 / Developing an Asset Allocation Scheme 158 Summary 162 INVESTING IN COMMON STOCK 165 COMMON STOCK INVESTMENTS 166 Opening Vignette 166 What Stocks Have to Offer 167Haas I the Markets Are Going ‘So Well, Why Don't | Feel Rich? im In International Investing, Currencies Can Make or Break You 198 CHAPTER 7 ES |] Sovon Engines That Drive the Ecosomy = 211 The Ter: Commardments of Financial Statement Analysis 25 CHAPTER & The Appeal of Common Stocks 167 / Putting Stock Price Behavior in Perspective 167 / From Stack Prices to Stock Returns 169 / The Pros and Cons of Stock Ownership 173 Basic Characteristics of Common Stock 176 Common Stock as a Corporate Security 176 / Buying and Selling Stocks 179 / Common Stock Vali 181 Common Stock Dividends 182 The Dividend Decision 183 / Types of Dividends 185 / Dividend Reinvestment Plans 186 Types and Uses of Common Stock 187 Types of Stocks 188 / Investing in Foreign Stocks 195 / Alcernative Investment Strategies 201 / Some Popular Investment Styles 203 Summary 206 ANALYTICAL DIMENSIONS OF STOCK SELECTION 207 Openi Security Analysis 208 Principles of Security Analysis 208 / Who Needs Security Analysis in au Efficient Marke.? 209 Vignette 207 Economic Analysis 210 Economic Analysis and the Business Cycle 210 / Key Economic Factors 212 / Developing an Economic Outlook 213 Industry Analysis 216 Key Issues 216 / Developing an Industry Outlook 218 Fundamental Analysis 220 ‘The Concept 220 / Financial Statements 221 / Key Financial Ratios 224 / Interpreting the Numbers 235 Summary 239 STOCK VALUATION AND INVESTMENT DECISIONS 240 Opening Vignette 240 Valuation: Obtaining a Standard of Performance 2411 abe Valuiag a Company and Its Future 241 Developing an Estimate of Future Behavior 247 The Valuation Process 249 Ive Got a Secret: Whisper Forecasts 2 ee Stock Valuation Models 251 Weighs in on B The Dividend Valuation Model 251 / Some and Sell Decisions 271 Alternatives to the DVM. 258 / Determinin Return 260 J The Price/#arnings (P/E) Approach 261 / Putting a Value on Tech Stocks 262 Expected Technical Analysis 268 Principles of Market Analysis 269 / Measuring the Market 270 / Using Technical Analysis 273 / Charting 275 Random Walks and Efficient Markets 279 A Brief Historical Overview 279 / Why Should Markets Be Ffficient? 280 / Levels of Market Efficiency 280 / Possible Implications 282 / So Who Is Right? 283 Summary 283 ayer 22 Spant pour © INVESTING IN FIXED-INCOME SECURITIES 285 cHapteR 9 BOND INVESTMENTS 286 Opening Vignette 286 Some Hints on Tips 302, Why Invest in Bonds 287 Putting Bond Market Performance in Perspective 287 / | Exposure to Risk 290 Essential Features of a Bond 292 Bond Interest and Principal 292 J Maturity Date 293 / Calf Features—Let the Buyer Beware! 293 / Sinking Funds 294 / Secured or Unsecured Debt 295 / Principles of Bond Price Behavior 297 ‘The Market for Debt Securities 298 Major Market Segments 299 / Specialty Issues 306 / A Global View of che Bond Market 310 Trading Bonds 313 Bond Ratings 313 / Reading the Quotes 316 Summary 319cuapren 10 BOND VALUATION AND ANatySiS 321 STINARR Opening Vignerte 321 ‘The Kehavior of Market Interest Rates 322 There's More to Bond Returns Thon Keeping Tabs on Market Interest Rates 322 / What Cau: Yield Alone 337 Rates to Move? 323 / The Terma Structure of Interest Rates Getting Started in Bond and Yield Cusves 326 Investing 349 ‘The Pricing of Bonds 331 Annual Compounding 332 / Semiannual Compounding 332 Measures of Yield and Return 334 Current Yield 334 / Yield-ro-Maturity 334 / Yield-to- Call 338 / Expected Return 339 / Valuing a Bond 341 Duration and Immunization 341 The Concept of Duration 342 / Measuring Duration 343 / Bond Duration and Price Volatility 345 / Uses of Bond Duration Measures 346 Bond Investinent Strategies 348 Passive Strategies 35 / Trading on Forecasted Interest Rate Behavior 350 / Bond Swaps 351 Summary 3£2 “Sant FIVE PORTFOLIO MANAGEMENT 353 CHAPTER 11. MUTUAL FUNDS: PROFESSIONALLY MANAGED INVESTMENT PORTFOLIOS 354 TRRRB Opening Vignente 354 ‘Adding ETF to your ‘The Mutual Fund Phenomenon 355 || investment Portfolio 366 An Overview of Motual Funds 355 / Open- or Closed- End Funds 361 / Exchange-Traded Funds 363 / Some Important Considerations 365 / Other Types of Investment Companies 369 Knowing Where to Look Is 4 ott the Battle 290 | Types of Funds and Services 372 | Types of Mutual Funds 373 / Investor Services 380APPENDIX A in Mutual Funds 384 Investor Uses of Mutual Funds 385 / The Selection Investin Process 386 / Investing in Closed-End Funds 389 / Measuring Performance 392 Summary 397 FINANCIAL TABLES A-1 Table Al Future-Value Interest Factors for One Dollar, FVIF A2 Table A.2 Future-Value Interest Factors for a One-Dollar Annuity, FVIFA A-4 Table A.3_Present-Value Interest Factors for One Dollar, PVIE AG Table A.4 —Present-Value Interest Factors for a One Dollar, Annuity, PVIFA A-8 Credits CA Glossary GA Index 11-OREWORD OMA is happy to introduce a now text, Funndamentals of fnvesting, ‘This textbook isa special edition of Funndamentals of buvesting, Fighth Edition, by Lawrence J. Gitaian and Michael D. Jochok, published by Addison Weste a Pearson Education company In addition co studying che material in Fundamentals of Investing, stu: dents who are preparing for the examination for LOMA. 356 will study assigned material from Introduction to Institutional Investing (Atlanta: LOMA, 2094), a textbook in CD-ROM format. LOMA selected! Fundamentals of Investing from among several commer: cially published textbooks because it best meets LOMA 356 course objectives, presents the material in a clear and engaging fashion, and provides a sound overview of the fundamentals of investing. In producing this customized ver- sion, We have removed material unnecessary to meeting course objectives. in places where the authors express opinions, it should be noted thar those opin: ions may or may not represent the views of LOMA, ‘The LOMA 355 examination is hased exclusively on the assigned reading materials in Fundamentals of Investing, including information in the body of the text and’in the chepter [eatures (such as Investing in Action), tigures, ang, tables; and Introduction t0 Institutional Investing. In addition to Fundamentals of Investing and Introduction to Institutional Investing, LOMA’ Test Preparation Guide for LOMA 356 (Atianta: LOMA, 2004) is, assigned for students preparing for the LOMA 356 exam. Used along with the assigned reading materials, the ‘Vest Preparation Guide will help you master the course material, Included in the Guide are practice exam questions, 2 full- scale sample examination in both paper and electronic fozm, and answers to all of the questions. LOMA recommends that you use the Test Preparation Guide for this course. Studies indicate thai students who use LOMA study aids consistently perform significantly better on LOMA. examinations than other students. ‘Acknowledgments [As is the case with all projects at LOMA, development of Fundamentals of Investing depended upon the contributions and combined efforts of many individuals. First, we would like co thank the authors, Lawrence J. Gitman and Michael D. Jochnk, for writing such an excellent ext and allowing LOMA to adapt it into this special edition. We would also like to thank Hal Hawkins, Senior Managing Editor, Pearson Custom Publishing; Donna M. Hendrickson, Special Sales Account Manager, Addison Wesley/Benjamin Cummings; and Sharon Stevens, Acquisitions Editor, Pearson Custom Publishing for their hard work and diligence and for making the arrangements for the adaptation. In addition, a pane! of external reviewers deserves LOMA’ gratitude for their willingness to cexd through the text and offer their comments to guide us in our adaptation: # Joe Amerell, Dirscror of Investment Accounting, Northwestern: Mutual Insurance Company# Douglas DeMay, CEA, VP, Investment Technology; Times Square Capital Management, CIGNA Corp. + Joseph Hanosck, Manager, Office of invesimencs, Nationwide Insurance CFA, View President, Private Placements, Hartford ent Company + Daniel C, Leimbach, Investment Manage | CCIM, FLMUM, Managing Director, Principal © Stephanie L. Riva, CF Real Estate Investors ‘+ Srinath Sampath, CFA, Manager, Public Bonds, Office of Investments, Nationwide * Barbara E. Seith, FLMI, Managing Director, MONY Capital Management ‘Many LOMA staff members contributed to the project as well. Jena L. Kennedy, FLMI, ALHC, ACS, PAHM, CLU, Assistant Vice President, has worked tirelessly to help get this texr and LOMA’ Fellow, Financial Services Institute progeam off the ground, Special thanks go vo Susan Conant, FLMI, HA, CEBS, PAHM, Senior Associate, and Gene Stone, FLMI, ACS, CLU, Senior Associate, who carefolly sead through several commercial texts ta help choose this fext. Susan was also a constant source of wisdom and good humor, Susan, along with David A. Lewis, FLMI, ACS, Senior Associate, made invalu- able contributions regarding the customization of the textbook As always, Joyce R. Abrams, §.0)., FLMi, PCS, AIRC, AIAA, AAPA, ARA, ALHC, PAH HIA, MHP, Assiscant Vice President, provided good advice and moral support. Members of the Examinations Department, including Robert H. Hantiey, FLMi, ACS, ALHC, CLU, ChEC, RHU, PAHM, Manager; Sean Schaefier Gilley, FLML, ACS, AIAA, HIA, CEBS, PAHM, MHP, AIRC, AAPA, ARA, FLHC, Senior Associate; Vivian “leeden, FILMI, CLU, FLHC, ACS, ALAA, PAHM, AIRC, ARA, Senior Associate; Lisa Kozlowski, FLMi, CLU, ALHC, ACS, AIA, PAHM, AIRC, ARA, FLHC, AAPA, Senior Associates and David A Lewis, FLMI, ACS, Senior Associate; all made valuable contributions to the project. Aurelia. K. Hemphill, Administrative Assistant Wl; Mary Rusch, Administrative Assistant; and Naralie Cape Sanders, Administrative Specialist, provided administrative support. Special thanks to Natalie for her good sense in resolving any and all problems. In LOMA’s Production Department, Kathleen Ryan, FLMI, PCS, AIRC, ALAA, ARA, PAHM, Production Coordinator 1, designed the cover; Amy Souwan, Producticn Coordinator Scheduling Coordinator, cheerfully coordinated the printing of che text and Stephen |. Bollinger, ACS, Manager, guided the project through production, Audrey H. Gregory, ACS, Inventory Manager, provided outstanding business support for the project and helped keep us alll on an even Re Finally, thanks to William H. Rabel, Ph.D., FLMI, CLU, Senior Vice President, Education Division, and Katherine C. Milligaa, FLMI, ACS, ALHC, Vice President, Edvcation & Training, for their ongoing encouragement and support Kristen L. Falk, FLMI, AAPA, ACS, AIAA, AIRC, ARA Senior Associate and Project Coord Education & Training Division, LOMA,Key Features of the Eighth Edition PREFACE 66 Je ashe est of fac, twas the worst of mes.” Noy you havent to bled into an English course. Bur that opening line from A Tale of Tivo Cities really does describe the behavior of the stock market over the pas couple of years. It applies especially to the Nasdaq market, which is home so most of the technology stocks—of both large and small technology companies. Consider, for example, that between January 1999 and March 2000, the Nasdaq Composite Indes, a popular measure of market performance, rose an eye-popping 130%, But in the next twelve months, from March 2000 0 March 2001, the index fell 57%. During that decline, four out of every ten stocks listed on the Nasdag—ahout 1,700 stocks—lost 50% or more of their value. Among the losers were a number ot weil-known echnology companies, including Sun Microsystems, Oracle Corporation, Cisco Systems, and Yahoo! fter nearly two decades of unprecedented growth in the stock market, tne events of 1999 and 2000 are a reminder that economic recessions and falling markets really aren't a thing cf the past after all. They do happen every now and then, ani investors have to be prepared to deal with thera. Fortunately, tar more often than not, the investor is faced with the pleasant task of trying (0 make the most of a good (“bull”) market. In the midst of market euphoria on fone hand and the prospect of serious market decline on the othes, stands the investor, wondering what to do with his or her investment capital. This book offers guidance in today’s invesiment environment. Focusing on both individual securities and portfolios, Fundamentals of Investing explains how to implement investment goals in light of risk-return tradeoffs. A conversational tone and liberal use of examples guide students, through the material and demonstrate important points. Using information gathered from both academicians and practicing invest ment professicnals, plus feedback from adopters, the eighth edition reflects the realities of today’s investment environment. At the same time, it provides a structured framework for successful teaching and learning Comprehensive yet Flexible Organization The text provides a firm foundation for learning by first describing the overall investment environment. Next it presents conceptual tools needed by investors—the concepts of risk and return and the basics of portfolio construc tion, It then examines cach of the popular investment vehicles—common stocks, bonds, and mutual funds. Following this series of chapters on invest ent vehicles comes a chapter on how to administer one’s own porttolio,We organized exch chapter according 0 a decision-making perspective, and we have been careful alsvays to point out the pros and cons of the various chicles nd strategies that we present. With this information, individual investors can select the investment actions that are most consistent with their objectives, In addition, we've illustrated investment vehicles and strategies in suich a way that students learn the decision-making implications and conse- quences of each investment action they contemplate Timely Topics Various issues and developments constancy ceshape financial markets and investment vehicles. Virtually all topies in this book rake into account changes, inthe investment environment. For example, sources of ia vestment information, as well as the process of online investing, are covered in Chapter 3. Similarly, coverage of tech stocks (in. Chapters 6 and 8) presents timely information needed fora thorough understanding of today’s investment opportunities. Globalization One issue that is resheping investing is the growing globalization of secuiti markets. As a result, Fundamentals of Investing continues to stress the giobal aspects of investing. We initially !ook at the growing importance of iatern: tional markets, investing in foreign securities (indirectly or directly), interna- tional investment pertormance, and the risks of iavesting internationally. In later chapters, popular international investment opportunities and strategies are described as part of the coverage o€ each spscifir type of investmnent vehicle. This integration of international :opics helps seudents understand the impor. tance of maintaining a global focus when planning, building, and managing an investment portfolio. Giobal topics are h’ghtighted by inclusion of a globe icon. Pedagogical Features tei This textbook has long been recognized for its numerous pedagogical feavures, designed .o help students focus their study of investments. Among the useful features it includes are Learning Goals, Investing in Action boxed essays, Investor Facts, Internet linkages, and a marginal glossary. Learning Goals Each chapter begins with Learning Goals, labeled with numbered icons (noted at left of head), thar efeaely state the concepts and materials 10 be covered. The Learning Goal icons are tied 0 tirst-tovet hsetding point at the chapter's end. ‘Alongside the chapter’s Learning Goals at the beginning of each chaptet is 4 brief story (opening vignette). It features an investment situation involving a real company or event and ties é ro che chapter gopies, to help motivate stu- dent interest in che chapter. and are reviewed point byInvesting in Action essays, called beesting ix Aetion, thar alsor we have revised and Each chapter features «wo boxes describe real-life investing situations or events. Altho retained a few of the most popular boxes from che previous edition, the majority are new. These high-interest boxes, which have heen written specifi cally for dis textbook, demonstrate concepts introduced in the text and heir abilities oven the studkats’ reading at a level consistent with Investor Facts Exch chapter also contains wo to three Investor Facts—brief sidebar items that give an interesting statistic or cite an unusnal investment experience. The facts and figures in chese boxes are intended to stimulate student interest and motivate further thought. For example, the Investor Facts box on page 167 (Chaprer 6) discusses the differences between a routine market decline, a market correction, and a bear marke:. The Investor Facts on page 213 (Chapter 7) compares GDP rates of various countries, Internet Linkages ‘The growth of the Internet and its increvsing us: in college conrsework has mpelled as to add Internet linkages. Hot Links boxes ace inte:spersed throughout. These inserts refer students to Web sites related to the topic being, sl in the text. Marginal Glossary New terms are set in boldface type and defined when first introduced in the text. In addition, each term appzars with its definition in the zext margin, (0 facilitate student learning and review, The page numbers en which these entries appear within the text are noted in boldface in the book's index, to make it easy to find these definitions. Summary Each summary lists the chapter’s key concepts and ideas, which correspond directly to the numbered Learning Goals presented ar the beginning of the chapter, The Learning Goal icons precede each summary item, which begins with a boldfaced restatement of the learning goal Acknowledgments Many people gave their generous assistance during the initial development and revisions of Fundamentals of I:westing. The expertise, classroom experience, and general advice of both colleagues and practitioners have been invaluable. Reactions and suggestions from students throughoue the country—comments, ‘we especially enjoy receiving—sustained our belief in the need for a fresh,A tew individuals provided signiticant subjece mates expertise in the i tial development of the book. They ace Terry S. Maness of Baylor Universiey, Arthur L. Schwartz, Jr, of the University of South Florida at St. Petersburg, and Gaty W. Eldred. Their contributions are greatly appreciated. In addition, [Addison-Wesley obtained the advice of a large acoup of experienced reviewers. We appreciate their many suggestions and criticisms, which have had a strong influence on various aspects of this volume. Our special thanks ge to the fol- lowing people, who reviewed all or part of the manuscript for the psevious seven editions of che book M. Fall Ainina Harry P, Guenther Joseph Newhouse Gary Baker Mahboubul Hassan Joseph F. Olivier Hiarisha Batea Gay Hatfield John Park Richard B. Bellinfante Robert D. Hollinger Thomas Patrick Cecil C. Bigelow Sue Beck Howard Ronald S. Pretekin Paul Bolster Roland Hudson, Je Stephen W. Pruite A.David Brummett_ Donald 'W. Johnson William A. Richard Gary B. Cain Ravindra 8. Kamath Linda R. Richardson Gary Carman Bill Kane William A. Rini Daniel J. Carrell Daniel J. Kaufmann, Jz Roy A. Roberson P.R. Chandy Nancy Kegelman Edward Rozalewicz David M. Cordelt Phillip T. Kolbe William J. Ruckstubl Timotny Cowling Sheri Kole David Russo Robert M. Crowe Christopher M. Korth Keith V. Smith Richard F. DeMong Thomas M. Krueger Pat R. Stout Clifford A. Diebold George Kutner Nancy E. Strickler James Dunn Robert T. LeChais Glena T. Sweeney Betty Marie Dyatt Chui IL ‘Amir Tavakkol Steven J. Elbere Larey A. Ly-ach Phillip D. Taylor Thomas Eyssell Weston A. 1McCormac — Wenyuh Tsay Frank J. Fabozzi David |. Mctaughlin Robert C. Tueting Robert A. Ford Keith Manko Howard E. Van Auken Albert J. Fredman imothy Manuel John R. Weige! Chaim Ginsberg Kathy Milligan Peter M. Wichert Joel Gold Warren E, Moeller John C. Woods Frank Griggs Homer Mohr Richasd HL. Yanow Brian Grinder Majed R. Muhraseb ‘The fallowing people provided extremely useful reviews and input to the eighth edition: Ping Hsiao, Sam Francisco State University Lacey Lyach, Roanoke College John Palfy, Wayne State University Michael Polakoff, University of Maryland at College Park Barbara Poole, Central Connecticut State University S. P. Umamaheswar Rao, University of Louisiana at LafayetteArthur L. Schwartz, Jt, University of South Florida at St, Petersburg Howard Van Auken, low State University Because of the wide variety of topics covered in the book, we called upon many experts for advice. We thank them and their firms for allowing uso draw oon theie insights and awareness of recent developments, to ensure that the text is a8 current as possible. In particular, we want to mention Jeff Buetow, CFA, BERC Services, Charlottesville, VA; John Markese, President, American Association of Individual Investors. Chicago, IL; George Ehenhack, Oppenheimer & Co., Los Angeles, Cals Mark D. Enwir, Northwestern Mutual Financial Network, San Diego, CA; Richard Esposito, Prana Investments, Inc., New York; Dennis P. Hickman, La Jolla, CA; Andrew Temte, CFA, Schweser Study Program, La Crosse, Wh; Martin P, Klitzer, Sunrise Capital Partners, Del Mar, CA; David M. Love, C.P. Eaton and Associates, Rancho Santa Fe, CAs David H. McLaughlin, Chase Investment Counsel Corp., Charlottesville, VA; Michael R. Murphy, Sceptre Investment Counsel, Toronto, Ontario, Canadas, Mark $, Nussbanim, PaincWebber, La Jolla, CA; John Richardson, Northern Trust Bank of Arizona, Phoenix, AZ; Pat Kupp, IDS, Inc., Dayton, OH; Richard Russell, Dow Theory Letters, La Jolla, CA; Mike Smith, Economic Analysis Corporation, Los Angeies, CA; Fred Weaver, Washington Mutual, Phoenix, AZ; and Lynn Yturri, BancOne Arizona, Phoenix, AZ. We greatly appreciate she suppor ef our colieagues at San University arid Arizona State University. Special thanks to attorney Robert J. Wright of Wright & Wrights, CPAs, San Diego, for his help in revising and updating the many tax discussions, and to Professor Edward Nelling of Drexel University for his help in preparing the material on tech stocks and tech-stock valuation, We also thank S. P, Unamaheswar Rao (“Spuma”) of the University of Louisiona for his work on the Hot Links and Karin Bonding of the University of Virginia for her useful feedback. Special thanks to Marlene Bellamy of Writeline Associates, La Jolla, California, for her work in updating ‘certain chapters and preparing chapter vignettes, Investing in Action boxes, and Investor Facts. ‘The staff at Addison-Wesley, particularly Donna Battista and Denise Clinton, contributed their creativity, enthusiasm, and commitment to this text- book. Freelance development editor Ann ‘Torbert, senior’ project manager Mary Clare McEwing of Addison-Wesley, Nancy Freihofer of Thompson Steele Production Services, senior production supervisor Nancy Fenton of Addison-Wesley, senior designer Regina Hagen of Addison-Wesley, and media producer Jennifer Pelland of Addison-Wesley warrant special thanks for shep- herding the project through the development, production, and Web site con- struction stages. Without their care and concern, this zext would not have evolved into the teachable and interesting text we believe it to be. Finally, our wives, Robin and Charlene, and our children, Jessica and Zachary, and Chris and Terry and his wife, Sara, played important roles by providing support and understanding during the book’s development, revision, land production. We are forever grateful to them, and we hope that this edition will justify the sacrifices required during the many hours we were away from them working on this book. Lawrenee J. Gi Michael D. JochnkBes Ns eeeCHAPTER 1 in just a few years, the world of investments has moved to a center stage in American life, Twenty years ago, most people's ra tae only exposure to investment news was a 10-second i, 5 announcement on the evening news about the change in the AY Ohd oh Dow Jones Industrial Average that day. PV ARSeR Ta BES Today, about half of all Americans own stocks, and 20% of them as only began investing after 1996. Cable TY stations such as CNNfn and ‘CNBC specialize in business and financial news. You can't pass a. newsstand without seeing headlines that scream, “Ten Stocks to’ Buy Now” ar “The Hottest Mutual Funds." Besides the Wall Street Journal, you can subscribe to Investor's Business Daily, Financial Times, _ Barron’, Kiplinger’ Personal Finance Hagatine, Money, Smart Moe formerly restricted to investment professionals, it creat playing field, The Internet also places enormdus‘afigin “information and a means of trading secur away. In short, technology makes investing much easier, but it'can alS0 inévease the fisks for inexperienced investors. + Regardless of whether you make transactions online or use'a: traditional broker, the same investment fundamentats presented in this textbook apply. The first chayter introduces you' to the types. pf x2 investments, the investment process, key investment veh} les). role of investment plans, and the :mportance of meeting liquidity reeds +a lecoming familiar with investment alternatives and:developingssire > ~ sans c reaiistic investment plans should greatly inciease your chance of TEED oiscusd inching wer the aaa ies Dene TaInvestments and the Investment Process tei) [ez] Hote: the Learning Goals shown af the beginning of the chapter fate keyed to text discussions Using these icons. investment any vehicle into which funds ean be placed with the expectation that it will generate positive Jacame and/or preserve oF increase its value returns the rewards frum investing, received as current income ‘and/or increased Valve, {investments that represent evi- fence of debt er ownership or the Boat rant to acu or sell an omership interest. property westments in real property or in ngible personal property irect investment Jovestment in which an investor rectly acquires a claim on a security or property. indirect investment investment made in 2 portfolio, or collection of securities or bronerties. . portfolio ‘Collection of securities of proper- ties, typically constructed to meet ‘one or more investment goals debt funds tent in exchange for interest income and the promised repayment of the loan at 3 given future date. THE ROLE AND SCOPE OF INVESTMENTS, 3 If you have money in a savings account, you already have at least one invest- iene co your name, An investment is simply any vehicle into which funds be placed with the expectation that ie will generate positive income and/or 1 its value will be preserved or increased. ‘The rewards, or returns, from investing are received in two basic ferms: current income ard increased value For example, money invested in a savings account provides current income in the form of periodic interest payments. A share of common stock purchased as an invesiment is expected to increase in value between the time it is put chased and the time it is sold Is cash placed in a simple (no-incerest) checking account an investment? Nu, because it foils both tests of the definition. It doe: not provide added income, nor does its value increase. (In face, the value of the cash in a checking account is likely to decrease, because itis croded over time by inflacion.| We begin our study of investments by looking at types of investments and at the structure of the investment process Types of Investments ‘When you invest, the organization in which you invest—whether it is a com pany or a government entity—offers you an expected furure benefit in exchange for the cusrent use of your funds. Organizations compete for the use of your funds. The one that will get your investment dollars is the one thas offecs a bencfie you judge to be better than any competitor offers. But, dif ferent investors judge benefits differently. As a cesult, investments of every type are available, from “sure things” such as earning 3% interest on your bank savings account, to the possibility of tripling your money fast by investing, in a newly issued dor-cem stock, The investments you choose will depend on your resources, your goals, and your perscnality, We can differentiate types of investments on the basis of a number of factors, Securities or Property Investments that represent debt or ownership or the legal right to acquire or sell an ownership interest are called securities, The most common types of securities are stocks, bonds, and options. The focus of this book is primarily on securities. Property, on the other hand, consists of investments in real property or tangible personal property. Real property is land, buildings, and that which is permanently affixed co the land. Tangible personal property includes items such as gold, artwork, antiques, and other collectibles Direct or Indipect A direct investment is one in which an investor directly acquires a clainl on a security or property. If you buy a stock or bond in order +o earn income or preserve value, you have made a direct investment. ‘An indirect investment is an investment made in a portfolio, or collection of securities or properties, typically constructed 10 meet one or more invest- ment goals, For example, you may purchase a share of a mutual fund. This share gives you a claim on a fraction of the entire portfolio rather than on the security of 2 single fism. Debt, Equity, or Derivative Securities Usually, an investment represents cither a debt or an equity interest, Dobe represents Funls lent in exchange for nd the promised repayment of the loan ae a given furure date,4 PART ONE equity ‘ongoing ownership in @ business or property derivative securities securities that are structured to exhibit characteristics similar to those of an underiying security & asset and that decve their value from the underlying security oF asset fee he chance that actua invest= bent returns will differ from those expected. speculation ‘tye purchase of high-risk invest- shent vehicles that offes highly Uncertain retutns and future value, short-term {avestments investments tat typically mat within one year. long-term investments investments with maturities of longer than a year or vith no maturity at al, Note oscsins of inteational resting te highighted by this ion, @ domestic investments. debt, equity, and derivative secu- rites of US-based companies foreign investments debt, equity, and derivative secu- rities of foreign-based companies. WHE RUVESTMENT ENVIRONMENT When you buy a debt instrament like a Bond, in etfect you tend money to the issuer, The issuer agrees to pay vou a stated rate of interest over a specified period of time, at the end of which the original sum will be returned. Equity represents ongoing ownership in a business or property. An equity investment may be held as a security of by title to a specific property. The most popular type of equity security is common stock. Derivative securities are neither debt nor equity. They derive their value from, and have characteristics similar to those of, an underlying security or asset. Options are an example: An itvestor essentially buys the oppostunity to sell o¢ buy another security or asset at a specified price during a given period of time. Options and other derivative security investments, though not so contttion a: debe and equity investments, have grown rapidly in popularity in recent years. Low- or High-Risk Investments are sometimes differentiated on the basis of risk, As used in finance, risk is the chance that actual investment returns will differ feom those expected. The broader the range of possible values or retucns associated with an investment, the greater its risk. Investors are confronted with a continuum of investments that range from low to high risk. Although each type of investment vehicle has @ basic risk characteristic, the actual level of risk depends on the specific vehicle. For example, stocks are generally believed to be more risky than bonds. However, it is nor difficult to find high-risk bonds thas are more risky than the stock of a financially sound firm such as IBM or McDonald's. Low-risk investments are those considered safe with regard r0 the receipt of a positive return. High-risk investments are considered speculative: Their Tevele of return are highly uncertain. Speculation offers high!y uncertain returns and future valve, so itis Figh-risk investment. Because ef this greater risk, the zeturns associated with eveculation are expected to be greater. Both investment and speculation differ from gambling, which involves playing ‘games of chance. In this book we will use che term investment for both invest- ment and speculation. Short- of Long-Term The life of an investment can be described as either short- or longterm. Short-term investments typically mature within one year. Long-term investments are those with longer maturities or, like common stock, with no materi at all I is not unusual to find investors matching the matu- rity of an investrnent to the period of ime over which they wish to invest theiz funds. Domestic or Foreign As recently as 10 to 15 years ago, individuals invested almost exclusively in purely domestic investments: the debt, equity, and deriv ative securities of U.S.-based companies. Today, these same investors soutinely also look for foreign investments (both direct and indirect) that might offer more attractive fetarns o: lower risk than purely domestic investments. Information on foreign companies is now readily available, and it is now rel: atively easy to make forciga investments. As a result, many individuals aow actively invest in foreign securities, Al aspects of foreign investing are there- fore routinely considered hroughout this hookfinancial institutions organizations that cha savings of govern nesses, and individuals into loans or investments, financial markets forums in which suppiiers and demandes of funds make finan ial transactions. ‘The Investment Process Note that Financial institutions participate in the financial ‘markets as well as transfer funds between supplies and demanders. Although the artows go only from suppliers to ‘demandes, for some trans- actions (e.g, the sae of a bond), the psincipat amount borrowed by the demander from the supplier (the lender) is eventually returned, THE ROLE AND SCOPE OF INVESTMENTS 3 The Structure of the Investment Process The javestment provess brings toge ders who need funds. Suppliers and demanders of funds are most often brought together through a financial institution or a financial macker (Occasionally, especially in property transactions, buyers and sellers deal dircetly with one another) Financial institutions are organizations. that chaunel the savings of governments, businesses, and individugls into loans o» investments. Banks and insurance companies afe financial institutions. Financial markets are forums in which suppliers and demanders of funds make financial transactions, often through intermediaries, They inchude securities, commodities, and foreign exchange markets. The dominant financial market in che United States isthe securities market. , bond markets, atl options markets. Similar markets nomies throughout the world. Their common feature is that the price of an investment vehicle at any point in time results from an equi librium berween the forces of supply and demand. As new information about retuinsand risk becomes available, the changes in supply and deraand may result ina new equilibrium or marker price. Financial matkets streamline the process of bringing together suppliers and demanders of funds, and they allow transac tions xo be made quickly and at a fair price. They also publicize security prices, Figure 1.1 diagrams the iivestment process. Note thet the suppliers of funds may teausfer theit resources to the demanders throayh financial institu sions, shrougi financial markets, o in direct transactions. As the broker fines show, financial insttusions can participate in financial markets as cither sup. pliers or demanders of funds. ier suppliers of extea funds with demsan Participants in the Investment Process. Government, business, and individ uals are the thiee key participants in che investment process. Each may act as a supplier and a demander of furtds. For the economy to grow and prosper, funds must be available to qualified individuals and to government and business. If Savings Banks Credit Unions he Ha | Direct transactions Money (short term) Capital (long term)Hote: Investor Facts offer inter sting ot entertaining tbits of information, AMERICANS LOVE STOCKS— A recent suey showed that 49% of Ameriars now 09 stocks or stock mutual funds ‘compared to just 19% in 49a: Sts dd stock mal funds account for abaut 36% of total household Financial assets, up fom 28% in 1995, As the ising equity markets ‘made stocks more poplar, ‘holdings of other fiparcial ‘sets prtelaly checking ‘savings; and mongy’maret * counts; money met inant nde ad declines etn “se Shy 8 ee Maa Star McClean Ban. Sette, ec hi ety frances es fot 08 Soy of oe Pe ose Bat Don f Conor fife cee Spreng ny song Note: Addresses of additional information squrces that can be found on the Internet are inter spersed throughout the chapter. {An Investing in Action box at the text's Web THE INVESTMENT ENVIRONIAENT heir exeess funds under fhoaeboards rather individuals began suddenly hiding than putting them in financial institutions or investing them in the financial mar kets. then government, business, and individuals in need of funds would have difficulty obsaining them. As a result, government spending, business expan. sion, and consumer purchases would decline, arié economic activity would slow. Government Alllevels of government—federal, state. and local—require ‘ast sums of money. Some goes to finince capital expenditures: long-torm projects selated to the construction of public facilities such as schools, hospitals, public housing, and highways. Usually the financing for such projects is obtained by issuing various types of long-term debt securities, Another demand for funds ‘comes from operating needs—the money required to keep the government eun- ring. At the federal ‘evel, for example, these funds are used to pay employee and other costs associated with national defense, education, public works, wel- fare, Social Security, Medicare, and so on, as well as interest on the naticnal debt. These operating costs are usually paid from tax revenue and fee collec- tions, However, when operating expenditures exceed government revenues oF when there is a timing mismatch beoween government receipts and payments, the government borrows funds—ty ically by issuing short-term debt secutities. Occasionally, governments are also suppliers of funds. if a state has tem- porarily idle cash, it may make a short-term investment to earn a positive retuzn, In genera, though, government is a net de-nander of funds. That is, it demands more funds than it supplies. The financial activities of governments, both as demanders and suppliers of funds, significantly affect the behaviac of financial institutions and financial markets. Business Most business firms requice large sums of money to suppost opera tions. Like government, brsine’ss has both long- and. shoct-term financial needs. On the long-term side, burinesses seck funds ro build plants, acquire equipment and facilities, and deve.op products. Their short-terin needs center on obtaining funds %© finance invextory and accounts receivable and to meet other operating costs. Businesses issue a wide variety of debt and equity secu: rities to finance these needs. Businesses also supply funds when they have excess cash. In fact, many large business firms have sophisticated cash-management operations and are major purchasers of short-term securities, But like government, business firms in general are net demanders of funds. Individuals You might be surprised to Jearn that the individual investor's role in the investment process is significant. Most individuals are move aware of their need to borrow than they are of the ways in which they put money into the financial system. They frequently demand furds in the form of loans to finance the acquisition of property—typically automobiles and houses. Yet, in Fact, the activities of individual investors help to satisfy the net demande af government and business for funds ia a vavicty or ways: Individual investors place tunds in savings accounts, buy debt o¢ equity instruments, buy insurance, make retirement plan contributions, and pur- chase various types of property. Although the individual site discusses the saving and investing habits demand for funds seems great, individuals as a group are net of “Generation Xers” suppliers of funds: They pst more funds into the financial SEL sscem than chey cake ouAPTER Getting investment information is now only a few "mouse clicks” away. Everything from stock quotations, fo News articles, to Well Street research ig available on the Web, There fare many Web sites that provide tutorials on financial information, (Cybeslnvest com contains contains free investing guides. Check out (Guides), Guides compare resources and veatures at hundreds of the best investing sites on the Web, The ‘guides can save you time and thus money— by revealing at a'glance hows investing Wed sites stack up against each other. Then you can amp to the site of your choice by clck'ng on {tg name, Especially eneck tne Investing 107 {guide under [Education Center) = THE mn Note: Two Investing in Action ‘boxes per chapter describe real life investing situations or elabo- rate on innovative investment vehicles. Those high-interest ‘mutual funds, and pension funds). Finar order to earn a significant return for cheir customers. For exampl ance company invests its premium receipts to earn returns that wi LE AND SCOPE OF INVESTMENTS Types of Investors When we refer co individuals in the inves iment process, we do so to differentiate households from gos ernment and business, We can further characterize the participation of individuals in che investment process in terms of who manages the funds. Individual investors manage their per- sonal funds in order to achieve their Financial goals. The indi vidual investor usually concentrates on earning a return on idle funds, building a source of retirement income, and provi security for his or her family. The accompanying Investing in Action box offers a quiz to determine a baseline on your investing “know-how. Individuals who lack the time or expertise to make invest- mene decisions often employ institutional investors—investment professionals who are paid to manage other people's money. These professionals trade large volumes of securities for indi viduals, businesses, and governments. Institutional investors include financial institutions (benks, life insurance compant’s, 1 institutions invest large sums 1 a life insur- permic boxes have Leen written for this rexthock, wth stuaent readers in aviné. Some ef the concept review ‘questions in the chapter are related to material in these boxes. {Individual investors investors who manage their own funds. istitutional investors investment professionals paid to manage other people's money. payments ¢0 policyholders or beneficiaries. Both individual and institutional investors apply similar fundamental principles. However, iusticutioual investors geuerally snyest largee sums of money on behalf of others and therefore are often more sophisticated in invescmeat knowledge and methods. The information presented in this text book is aimed primarily at individual investors; it represents only the first step toward developing che expertise needed to qualify as an institusional investorsPART ONE Test Your Investment !0 Heoxz meds 22 you know about investing? Take this investor literacy quiz, developed by ‘Money magazine and the Vanguard Group to test the investment savvy of 1,500 mutual fund investors, The average score (for the full 20-question guia) was only 27%, But don’ despa f you, to, the answers to = tions from this book. jattfent hes offered the nest cree ‘against inflation over long periods of time?” jane market funds and bank accounts. Goverment National Mortgage "Association securities (also known ar 'Gihinie Macs or GNMiAs). c? Stocks: @, Corporate bonds. 2, Common stocks always provide highor ve turfs thar: bonds or money market invest monte a, True. '. False, 3, Interest earned by municipal bonds is ex ‘empt from federal income tax 2. Tue, False. 4, If interest rates declined, the price of @ bond fr bond fund generally would: 2. Increase, b. Decrease. ©. Stay about the same. d- itis Impossible to predict. 5. If you own anly U.S. stocks in your invest- ment portfolio, you will reduce your overall risk by adding international stocks. a. True, b. False, THE INVESTMENT ENVIRONMENT 6, Which market benchmark oF stock exchange isthe best gauge of the performance of the entire U.S. stock market? 2. S&P 500 Index. b. Wilshire 5000 fatal Market Index. . Dow Jones Industrial Average. 4. Nasdaq Composite Index. 7. Ifyou invest in a 401(k) plan at work, you: are not eligible to contribute to.an. RAS? <3 L. 11% per year. ©. 19% per year, 4. 28% per year. 8. Which of the following is not an attribute of rutual funds? a. Diversification. ». Professional management, ©. Guaranteed return 1d. None of the atove. 10. If your irivestment returned 109% last year and inflation was 3%, your “real” (he. ad- justed for inflation) return waszoes 8% a 3.3%, bm, ©. 13%. 30%. : 11, A mutual fund that invests in government securities Is guaranteed not to lose money. a. True. b. False, wens Answvars’ 1 (ch; 2 (by; 3 (a); 4 (a); § (a); 6 (bl; 7 (bY; 8 (oi; 9 (c); 10 Ub); 11 Wb. ‘Sources Laura Lali, What’ Your nesting IO?" Maney, ‘August 2000, pp. 81-52; que downloaded trom talmoneycom/egrbin/money/polls vanguard? ‘nguard pleCHAPTER 1 THE ROLE ANO SCOPE OF INVESTMENTS a | Investment Vehicles 163 short-term vehicles savings instruments that usually have lives of 3 year or less iquiaity the ability af an investment to be converted into cash quickly and with Title or no loss in value ‘common stock ‘equity investment that represents ‘ownership in a corporation; each Share represents a fractional own- ‘ership interest in the firm. A wide variety of investment vehicles are available to individual investors. Vehicles differ in terms of maturities or lives, costs, retura and risk character istics, and tax considerations. We devote the bulk of this book—Chapters 6 through 11—to describing the characteristics. special features, returns and risks, and possible investment strategies thar can be used with vehicles avail able to the individual investor. Here we will introduce these investment vehi cles. Table 1.1 summarizes the iavestment vehicles covered in this book. Short-Term Vehicles Shott-term vehicles include savings instruments that usually have fives of 1 year or less. Short-term vehicles generally carry little or no risk. Often such instruments are used t0 “warehouse” idle funds and earn a return while Jong term vehicles are being evaluated. They are also popular among conservative investors, who may use short-term vehicles as a primary investment outlet. Short-term vehicles also provide liquidity. That is. they can be conver d into cash quickly and with litle or no loss in value. Provision for liquidity is an important part of any financial plan, The role of short-term vehicles in finan- cial planning and the key features of the most popular short-term vehicles are discussed later in this chapter. Common Stock Common stock is an equity investment that represents ownership in a corpo: ration. Each share of common stock represents a fractional ownership interest in the firm, For example, one share of common stock in a corporation that has 10,000 shares outstanding would represent 1/10,090 ownership interes. Next to short-term vehicles and home ownership, common stock is the must pop- ular form of investment vehicle age sg areca enc i naan eee [TaBLesa arene Toyestment Vebicles con ooh or ates SPAS Where Covered Type Deserption Examples inThis Book ‘Shoreterm ‘Sevings insirumente with ves oft year Deposit accounts ca vehicles fof less. Used to warehouse ide funds Series EE savings bonds nt and to provide liquidity US.Tressury bills (Fells) Che Contficates of deposit (CDs) Ch. Commercial paper cha Banker's accoptances cn Money market mutual funds Ch. 1 Common stock Equity investment vehicles that represent chs, 6-8 ‘ownership in a corporation. Fixecsncome Investment vehicles that offer a fixed Bonds chs. 9, 10 ecunties periodic return Mutual funds Companies that raise money from ch. sale of sheres and invest in and professionally manage a diversified portfolio of se ties.PART ONE dividends petiodic payments made by Firms to their shareholders. capital gains the amount by which the sale price ofan asset exceeds its urge inal purchase price fixed-income securities ‘investment vehicles that offer a heed periodic tur. bonds long-term debt instruments (0Us), issued by cosporations and governments, that offer a known interest return plus return of the bond's foce volue at matur'ty. preferred stock p interest in a corpura- 1s-a stated dividend rate, paytent of which is given prefer- tence aver common stock divi- ddends of the same firm. convertible security a fixed-income obligation (bond ‘or preferred stock) with a feature permitting conversion into a specified number of shares of common stack HoT. Successful investing can be surprisingly THE INVESTMENT ENVIRONMENT The recuen on investment in common stock comes from either of two sources: dividends or capital gains. Dividends are periodic payments made by the corporation to its shareholders from its current and past earnings. Capital gains result from selling the stock (or any asset) at a price that exceeds its original purchase price. For example, say you purchased a single share of One Tech Industries common stock for $40 per share. During she first vear you owned it, you received $2.50 per share in cash dividends. Ar the end of the year, you soté the stock for $44 per share. If we ignore the costs associated with buying and selling the stock, you earned $2.50 in dividends and $4 in capital gains ($44 sale price—S40 purchase price). Fixed-Income Securities come securities are investment vehicles that offer « fixed periodic return, Some forms offer contractually guaranteed returns. Others have spec- ified, but not guaranteed, returns. Because of thcir fixed returns, fixed-income securities tend to de popular ducing periods of high interest rates, véhen investors seek to “lock in” high retuens, The key forms of fixed-income stex- tities ate bonds, preferred stock, and convertible secvrities. Bonds Bonds are the long-term debt instruments (IOUs) issued by corpore- fions and governments. A bondholder has a contractual right to receive a known interest returt, plus return of the bond's face value (the stated value given on the certificare) at ratucity (rypically 20 to 49 years). If you purchased 2 $3,000 bond paying 9% interest in semiannual iastallments, you would expect to be paid $45 (9% X % year X $1,009) every 6 months. At matutity you would receive the $1,000 face valne of the bond. An investor may be able to buy of sell a bond prior to maturity. Preferred Stock Like common steck, preferred stock vepresents an owner- ship interest in a corporation, Unlike common stock, preferred stcck has a stated dividend rate, Payment of this dividend is given preference over common stock dividends of the same firm. Prefersed stock has no maturity date. Investors typically purchase it for the dividends it pays, but it may also provide capital gains. Convertible Securities A convertible security is a special Sine ahd auaightiorward: These arervery type of fixed-income obligation (bond or preferred stock). It bese investing ‘tes: tog ons _ has a feature permitting the investor to convere it into a spec- smartMoney.corn. Scroll down the homepage ified number of shares of common stack. Convertible bonds to Smart Maney University and read the sec- lions oninvesting 10T and’Stetege ivesting and convertible preferreds provide the fixed-income benefit of that explain the fundamentals of stocks, a bond (interest) or preferred stock (dividends) while offering, bonds, and mutual funds. the price-appreciation (capital gain) potential of common stockCHAP THE FEELING'S MUTUAL— Investors have put more than 417. trilos of investment asses into the almost 8,000 rmtuat funds in the United States, The 4,140 stock funds ted the way with $4.2 trilion (60%) ofthe total, followed by 700 taable money market fanis wth $1.5 trun (2%). Scarce: “rads in at ard Investing, uly 200 drvestent Company Tstte, Washington, BC, sags 30 2000, dowland fom vwnnicorg ‘mutual fund a conpany that raises money from sale ofits shares and invests in an¢ professionally manages 2 diver fed portfulia of securities money market mutual funds imuiuat funds that invest solely in short-term investment vehicles, options Securities that give the investor ‘az opporturity to sell or auy Enother security at a specified Drice over a given period of time. tures Best nrg ations ne ting that the sellers of such fontrects wil make delivery and the buyers of the contracts wilt fake delivery of a specified com- mmodity or financial instrument at some specific date, at a price ‘agreed on at the time the con: Wract is sold real estate Entities suck as residential Ihomes, raw land, and income broperty tangibles {investment assets, other than real estate, that can be seen or touched. THE ROLE AND SCOPE OF INVESTRIENTS 4 Mutual Funds A company thac raises money from sale of its shares and invests in and protes sionally manages a diversified portfolio of securities is called a mutual fund. Investors in the fuad own an interest in che fund's portfolio of securities. All matual funds issue and repurchase shares of the fund at a price that retlects the value of the purtfolio atthe time the transaction is made. Money market mutual funds are mutual funds that invest solely in short-term investment vehicles Derivative Securities As noted earlier, derivative securities derive theit value from that of an under lying security or asset. They typicatiy possess high levels of risk, because they usually have uncertain returns or unstable market values. But, because of their above-average risk, these vehicles also have high levels of expected return, The key denvative securities are options and futures. Options Options are securities that give the investor an opportunity to sell or buy another security at a specified price over a given period of time. Most often, options are purchased in order to take advantage cf an anticipated change in the price of commen stock. However, the purchaser of an option is not guaranteed any zet:im and could even lose the entire amount invested because the option dves not become attractive enough to use. Aside from theie speculative use, options arc somesimes used to protect existing investment positions against losses. Three common types of options are pus, calls, and warrants Futures Futures are Ingally binding obligations stipulsting that the sellers of such contracts will make delivery and the buyers of the contracts will rake delivery of a specified commodity or financial instrument at some specific date, at a price agreed on at the time the contract is sold. Examples of com- modities sold by contract include soybeans, pork bellies, platinum, and cocoa. Examples of financial futures are contracts for Japanese yen, U.S. Treasury securities, interest rates, and stock indexes. Trading in commodity and finan- cial futures is generally a highly specialized, high-risk proposition. Other Popular Investment Vehicles Various other investment vehicles are also used by investors. The most common are real estate, tangibles, and tax-advantaged investments. Real estate consists of entities such as residential homes, raw land, and a varicty of forms of income property, including warchouses, office and apart ‘ment buildings, and condominiums. The appeal of real estate investment is the potential returns in the form of rental income, tax. write-offs, and capital gains, Tangibles are investment assets, other than real estate, that can be seen.42 PART ONE HE INVESTMENT ENVIRONMENT oor touched, ‘They include gold and other precious metals, gem- stones, and collectibles such as coins, stamps, artwork, and estate tangibles, and tax-advantaged antiques. These assets are purchased as investments in anticips- iavestmends ate cieouresd coment tion of price increases. Because the federal income tax rate for Web site, Click on che Web chapter titled Real Estate and Other Tangible Investments, an individual can be tax-advantaged investments ‘investment vehicles and state gies For legally reducing one's tax babitty. high as 39.6%, many mvestors look for vestments. These are investment vehicles and strategies for legally reducing one’s tay liability. With them, investors find that their after-tax rates of return can be far higher than with conventional investments. Making Investment Plans The process of investing can be carried out by following a logical progression of steps. It is important that your investment plans take into account the impact of taxes. Your plans also should be responsive to your stage in the life cycle and to the changing economic environment. Steps in Investing Investing can be conducted on a strictly intuitive basis ot on the basis of plans carefuily developed to achieve specific goals. Evidence favors the inore logical approach that begins with establishing a set of overall financial goats and then, developing and executing an investment program consistent with those goals The following brief overview of the steps in investing provides a framework for discussion of the concepts, tools, and techniques presented throughout the book. Step 1: Meeting Investment i‘revequisites Before investing, you must make certain that the necessities of life are adequately provided for. This cat- egory includes funds for housing, fad, transportation, taxes, and clothing. In addition, a pool of easily accessible funds should be established for meeting emergency cash needs, (Meeting liquidity needs is Detailed information on meeting life insurance noods is available on this text's Web site, Click “#scussed later in this chapsce} onthe Web chapter ted Tax Advantaged Another prerequisite is adequate protection against the Investments and then on Deferred Annuities _Josses that could resulr from death, illness or disability, damage and Singlo-Pramium Life Insurance. ‘vestment goals the Financial objectives that one wishes to achieve by investing. to property, or a negligent act. Protection against such risks can be acquired through life, health, property, and fiabiliry insurance. Step 2: Establishing Investment Goals Once you have satisfied the pre- requisites and set clearly defined financial goals, the next step is to establish investment goals, Investment goals are the financial objectives you wish to achieve by investing. Clearly, your investment goals will determine the types of investments you will make. Common investment goals include 1, Accumulating Retirement Funds. Accumulating funds for retirement is the single most important reason for investing. Too often, people tend 0 rely heavily on Social Security and employers for retirement funds. It is of the utmost importance t0 review the amounts that ean realistically be expected from these sources. You can then decide, on the basis of your retirement goals, whether they be supplemented through your oa investment progeam. The earlier in life ll be adequate to meet your needs. If they aze not, they mustCHAPTER 1 THE ROLE ANO SCOPE OF INVESTMENTS 13 you assess your retirement needs, the greater your chance of accumulating suf ficient funds to meet them. 2, Enhancing Current Income. Investments enhance current income by carning dividends or interest. Retirees frequently choose investments offering, high curvent income at low risk. The ides of a retired person “clipping coupons” —collecting interest—from high-grade bonds is a fair description of what most senior citizens shoutd be doing at that point in their lives Taxadvantaged investments are discussed on the tax’s Web site, Click on the Web chapter 3, titled Tax-Advantaged Investments. TT ‘investment plan a written document describing how funds will be invested and Specifying the target date for Schieving each investment goal {nd the amount of tolerable risk. aving for Major Expenditures. Families often put aside money over the years to accumulate the funds needed to make ESA major expendicures. The most common of these are the down paynient on a home, education, vacation travel, and capital to stact 2 business. The appropriate types of investment vehicles depend on the purpose and the amount of money needed. For purposes such as the down payment on a home or a child’s education, for example, much less risk should be tolerated than for other goals, The attainment of such basic go: ls should not, if posstble, be plaved in jeopardy. 4, Sheltering Income from Taxes. Federal income tax law allows certain noncash charges t0 be deducted from specified sources cf income. Such ceductions reduce the amount of firal raxatle income. Obviously, if a person can avoid (ar deie*) paying raxes on the income from an investment, he or she will have more funds feft for reinvestment. Step 3: Adapting an Investment Plan Once your general goals have been established, you should adope an investment plan—a written document describing how funds will be invested. A series of supporting investment goals can be developed for each long-term goal. For each goal, specify t'.e target date for achieving it and the amount of tolerable risk. Generally, the more important the financial objective, the lower the risk that should be assumed. Suppose, for example, one long-run goal is to accumulate $80,000 in cash by the end of 10 years. That goal could spelled out as a plan to accumulate $80,000 in cash by investing in a port- folio evenly divided between low-risk and speculative stocks providing a total return of 10% per year. The more specific you can be in your statement of investment goals, the easier it will be to establish an investment plan con- sistent with your goals, Step 4: Evaluating Investment Vehicles Once you have your inverment goats ad plan laid ou, you will want to eralunte ‘The Investing in Acticn box at the book’s Web investment vehicles by assessing each vehicle’s potential return site describes the role of professional financial and risk. This process typically involves valuation, the use of planners in helping theirciients formulate tnvestment goats and plans. measures of return and risk co estimate the worth of = invest (Chapter 4 offers a general discussion of the proce- dures for measuring these key dimensions of porential investments. Subsequent chapters focus on the valuation of spe- cific vehicles.) Step 5: Selecting Suitable Investments You now gather additional infor mation and use it to select specific investment vehicles consistent with your goals, The best investments may not be those that simply maximi ¢ return4a PART ONE diversification the inclusion of 2 mimber of dif- fectinememeicesina italia to increase returns or recice risk. THE INVESTMENT ENVIRONMENT Other factors, such as risk and tax considerations, may also be crucial. For example, t0 receive maximum annual dividends, you aight purchase the cemimon stock of a firm expected to pay high dividends. However, ifthe fcr whose stock you purchased goes bankrupt, you could lose the money. The stock of a fiem that pays lower dividends but with less risk of bankruptcy might have been a bettae choice. Careful selection of investment vehicles is essential to snecessful investing, Vehicles should be consistent with established goals and offer acceprable levels of return, ss's, and value. Step 6: Constructing a Diversified Portfolio Selecting suitable investments involves choosing vehicles that enable you to achieve investment goals and that optimize return, risk, and investment values. To do this, you will assemble an investment portfolio that meets one or more investment goals. For example, your portfolio might contain common stock, government bonds, and shor term investments, Diversification is the inclusion of a number of different investment vehicles in a portfolio to increase returns or reduce risk. By diver- sifying in this way, investors are able to earn higher returns or be exposed to less risk chan if they limit their investments to just one or two vehicle Diversification is the financial term fcr the age-old advice “Don’t put all your eggs in one basket.” (Chaprer $ includes discussions of diversification and cther modern portfolio concepts.) Step 7: Managing the Portfolio Once you have consiructed you: portfolio, you should measte its actual behavior in relation to oxpected pesformance. lf the investment results are not consistent with your objectives, you may need to take corrective action. Such action usually involves selling certain invest- ments and using the proceeds to acquire other vehicles for the portfolio. Portfolio management involves ‘monitoring the portfolio and sestructusing it as dictated by the actuai behavior of she investments. (Portfolio management is discussed in detail in Chapter 11.) ‘The Investing in Action box summarizes some general tips for suc~ cessful investing. Considering Personal Taxes Besides developing plans for achieving your specific investment goals, it’s also imporcant tc consider the tax consequences asso~ inaneial planning is too important to leave to __ciaied with various investments. A knowledge of the tax laws ck. The Wee is extromaly useful in helping can help you reduce taxes. By doing so, you increase the amount investors establish ther investment plans. The has an interactive walop these ‘goals. Because tax laws are complicated and subject to frequent Wall Street City Web | program that helps investors, of after-tax dollars available for achieving your investment plans Visit the following address to earn Se aeienteret men oni ie ies castes aaa hee more about planning and choose [Other ston, we presen only the key concepts and how they apply Features] and then [Financial Planning) to popular investinene transactions Basic Sources of Taxation The two major types of tases are those levied by the federal yovernment and those levied by state and local governments. The federal income tax is che major form of personal taxation, Federal rates currently range from 10 t0 35% of taxable income. State and local taxes vary from area to area. Some states have income taxes that range as high as 15% or more of income. Some cities, especially large East Coast cities, also have local income taxes that typically rangeCHAPTER 1 THE ROLE AND SCOPE OF Lessons for Investment Success he stock market has taken investors on a roller coaster ride in recent years. Even in such voletile times, however, some basic rules still apply. Becoming a successful investor takes time and effort; there are no sure-fire schemes for beating the market. Here are sonte tips to help you get started on the road to financial se- curity. + Hamess the power of compounding. With compounding, time is your biggest elly. The longer you invest your money, the faster it will grow. If you earn a 9% annual return on your investment and reinvest your yearly earnings at the same rate for 0 20-year pe riod, your overall return is 460%, an averag’ auntal roturn of 23% (4609/20). Stact now: weiting will cost you monay. If you invest $2,000 a year for 10 years ($20,009 total) ct ‘8% per year, in 35 years you'll have $198,422, But wait 10 yoars and invest $2,000 a year for 25 years at 8% per year, and your (consider ably greater) $50,009 investment will be only ~ $148,212 at the end of that same 35-year pe- find, You can start small. Invest just $200.90.” 10% and you'll have almost $20,000 in'25"" =" years. Make investing a habit now. + Don’t wait for the “right” time to invest. - Théte isn’t One! The “best” time $0 invests. ‘owas can alway find easanto pat of > taking the plunge: Its an election yeat, the, “market jp to9,high, there’s.a crisis.somewher in the world, Studies show that it’s more im- portant to invest than to plck the right time, In the short run, market activity is unpre- dictable, even for the experts. Don't make ex- ‘cuses, lke you are too busy, investing is 00 hard, or you can’t possibly save enough for college or retirement. Investing is one of the best uses of your time. Rethink your prior- ties: Is it more important to go to the movies s aS INVESTMEN| 0 plan for your financial frre? And don't be immidated by tho investment procase Set pea ies ete rence Simple investments thet you understand Sree you galncontol of yourfinances, your | ee + Diversity your portfte Spreading vour money aon diferent ypc of vestments {stocky than puting al your ages in one poets besa pies aie Jo donn others go up, ona vie vren Brera Your portals by vesting tn several taped of sours: short tom voles auch semoney marke fonds, Intermediate term tronds or bond funds, ane fore longer Growth stocks or grown mutual unde You ret alse heve some ntematonal stocks of thutul unde Dent concentrate to Rew Inne Industry er buy ust one or two sto No ove knowe which actor wl be het tomor + Monitor your investments, Don't just buy se cuieg (eeoldthem ferover vie: Your ig ont to seek your press against your goals. Weed ‘out your poor, per- formore ond evaluat curent holinae vets ater nmpetnent spesrariee Dor be tg, quek tn nto tak or muta find or folcyase,iterthac hot stack dp, though: Do Me eg reason fo by orsehs Yorn ‘Sources: Jonathaa Clements, “Don't Ignore Luck’ Role in Steck Paks” Wall Stroet Journal September 26, 2000, . Ct; Jonathan Clements, “Lessons from the Schoo! of Fard knocks, Wal Steet Journal, Maren 14,2000. Ct; “Money 10; Basics of Investing” Manay.com, cownloades “com wor monarcom/money/itn, Peter Peaes, “Tan Tips for Successful Investing” The Motley Foot, September 13 12000, downloader from fooleam between 1% and 5% of income. In addition to income taxes, state and local governments rely heavily on sales and property taxes, which vary from com munity to community, as a source of revenue. Income taxes atthe federal, state, and local levels have the greatest impact oon security investments, whose returns ase in the form of dividends, Property taxes can have a sizable impac. on real estate and ingreases in value and other forms of property investment‘ART ON E INVESTMENT ENVIRONMEN Types of incame The income ot individuals is classified into one of three basic categories defined below. 1, Active income consists of everything from wages and salaries to bonuses, tips, pension income, and alimony. Active income is made up of income earned on the job as well as most other forms of noninvestment income. 2. Portfolio income is earnings generated from various types of investment holdings. This category of income covers mest (but not all) types of investiments, from savings accounts, stocks, bonds, and mutual funds to options and furuces, For the most part, portfolie income consists of interest, dividends, and capital gains (the profit on the sale of an investment). 3. Passive income is a special category of income, composed chiefly of income derived from real estate, limited partnerships, and ather forms of tax-advantaged investments “The key feature of these categories is that they limit the amount of deduc- sions (write-offs) that cant be taken, particularly for portfolie and passive income. The amount of allowable deductions for portfolio and passive income is limited t0 the amount of income derived from these two sources. For example, if you had a total of $380 in portfolio income for the year, you could deduct no more chan $380 in investmert-related interest expense. For deduc- ‘ion purposes, the port‘elio and passive incom caiegories cannot be mixed or combined with each other or with active income. Investment-related expenses cari be used only to offset portfolio income, and (with a few exceptions) pas- sive investment expenses can be used only to offset the income from passive investments. Ordinary Iacome Regardless of whesker it’s classified as active, portfolio, or passive, ordinary income is za:ed at one of six rates: 10, 15, 25, 28, 33, or 35%. There is one structure of 12x sates for caxpayers who file individual returns and another for those who file joint returns with a spouse. Table 1.2 shows the tax rates and income brackets for these two categories. Note that the rates aze progressive. That is, taxpayers with taxable income above a spec ified amount are taxed at a higher rate. ‘An example will demonsteate how ordinary income is taxed. Consider the Ellis sisters, Joni and Cara. Both are single. Joni’s taxable income is $18,000. Cara’s is $35,000. Using Table 4.2, we can éaleulate their taxes as follows: [TABLE T.2 tax rates and income Brackets for todividat and Joint Returns (2003) Taxable Income Tax Rotes Individual Returns 10% 3010 $7000 ‘$0 to $14,000 15% Over $7000 to $28,400 Over $14,000 to $56,800 25% ‘Over $23,400 to $68,800 (Over $56,800 to $114,650 28% (Over $68,800 to $143,500 Over $114,650 to $174,700 33% Over $143,500 to $311,950 Over $174,700 to $311,950 35% Over $211,950 Over $222,950CHAPTER P THE ROLE AND SCUPE GF INVESTMENTS Ms Jon (0.15 % $18,000) = ara (W.1S X $28,400) + [0.25 x ($36,000 ~ $28,400)] 4,260 + $1,900 = $6,160 “The progressive nature of the federal income ta structure eaa be seen by the fact that although Cara’s taxable income is ewice that of Joni, her income tax is about 2.5 times Joni’s Capital Gains and Losses 4 cupital asset is property owned and used by the taxpayer for personal reasons, pleasure, or investment. The most common types are securities and real estate, including one’s home. & capital gain repre- sents the amount by which the proceeds from the sale of a capital asset exceed its original purchase price. Capital gains are taxed at two different rates depending on the holding period ‘The capital gains tax rate is 15% if the asset is held fo more than 12 months. This 15% capital gains tax rate assumes that you're in the 25%, 28%, 23%, oF 35% tax bracket. If you're in the 15% tax bracket or below, then the capital gains tax rate on an asset held for more than 12 months is just 5%. If the asset is held for fess than 12 months, then the amount of any cap: ital gain realized is added vo other sources of income, ané the total is taxed at the rates given in Table 1.2. For example, imagine that James McFail, a single person who has other taxable income toraling $45,000, sold $00 shares of stock at $12 per share. He originally purchased this stock at $10 per share. The total capital gain on this transaction was $1,000 1500 shares x (§12/share ~ §1/share)]. ‘Thus James's taxable income would total $46,000, which puts him sn the 25% tax bracket (see Table 1.2). . If the $1,000 capital gain resuked from an asset that was held for more than 12 months, and because James is in the 25% tax bracket, the capital gain would be taxed at the maximum rate of 15%. His toral tax would be calcu- lated as follows: Ordinary income ($45,000) (0.13 X $28,400) + (0.25 x (845,000 ~ $28,400} $4,260 + $4,150 = $8,410 Capital gain ($1,000) (0.15 x $1,000) = 10.00 Total tax $8,560.00 James's total tax would be $8,560.00. Had his other taxable income been below $28,400 (i.e., in the 15% bracket), the $1,000 capital gain would have been taxed at 5% rather than 15%. Had James held the asset for less than 12 ‘months, his $1,900 capital gain would have been taxed as ordinary income, ‘which in James's case would resule in a 25% rate, Capital gains are appealing to investors because they are not taxed until actually realized. For example, if you own a stock originally purchased for per share that at the end of the tax year has a market price of $60 per share, you have a “paper gain” of $10 per share. This paper (unrealized) gain is not taxable, because you scill own the stock. Only realized gains vve taxed. If you. SAT ONE SHE INVESTMENT ENVIRDNME sol the stack for $60 per share during the tax year, you would have a real- izedand therefore taxable—gain of $10 pee share capital loss A capital loss eesults when a capital asset is sold for less thane its original the amount by which the pro purchase price. Before taxes are calculated, all gains and losses must be netted ceeds irom the sale of @ capital Gur. Up ro $3,000 of net losses can be applied against ordinary income in any asset are lose thar its original ee year, Losses that cannot be applied in the current year may be carried forward and used to offset future income, subject ro certain conditions. net losses the amount by which capital losses exceed capital gains; up to $3,000 of net losses can be Investments and Taxes The opportunicics created by the tax laws make tax planning important in the investment process, Tax planning involves looking avvled against ordinary income ar your earnings, both current and projected, and developing stsateges that in any year will defer and minimize the level of taxes. The tax plan skould guide your otannin investment activities so that over the Tong run you will achieve maximum Haerresent ofstategies _affertax returns for an acceptable level of risk. For example, the face that cap- that will defer and minimize an ital gains are not taxed until actually realized allows you to defer tax payments inv level of taes ove the on them os well as control the timing ofthese payments, Howeven, investments {ong run. that are likely to lead to capital gains income generally have higher risk than those that provide only cutrent investment income. Therefore, the choice of investment vehicles cannot be made solely on the basis of the possible reduc~ tion of tax payments. The levels of both return and risk need to be viewed in light of thei tax effects. It is the after-tax return and associated HOT. riste thst matter. Tax plans should also reflect the (1) form of returns— reni income, capital gains, oF tax-advantaged income—and the timing’ of loss recognition and profit taking. One common strategy is to claim losses as coon as they accur and to delay profit taking. Such ar approach allows you to benefit com the tax de ‘uctibility of a loss and to delay having to claim income from gains. Tax planving, which is usually done in coordination with an accountant, tax expert. or 11x attorney, is mos: common among individuals with high levels of income ($200,000 or more annually). Yet sizable savings can result for investors with lower incomes as well. ‘Tho material on tax stratogias and taxadvan- web Investing Over the Life Cycle TAX BITE=If you invest just Investors tend to follow different investment philosophies as they move $2,000 a:year in taxable through different stages of the life cycle. Generally speaking, most investors {counts and investments for ors an ‘ me ieee ind on tend to be more aggressive when they're young and more conservative as they an 8% average compounded grow older, Typicatly, investors move through the following investment annual rate of return, youll Stages. accumulate about $227,000— anil you pay Uncle Sam his share. Then you wil have only $175,230, asuming that 2 averace fede income tax ‘rte af 31% is palied to our earings above the total Most young investors, in their ewenties and thirties, tend to prefer growth- fevesent of $60.00 oriented investens that sttess c2?al gains rather than eurrene income, ($2000 30 yen) Taes Often young investors don't have sich inthe ay of isectabe funds So cap from the investment By nearly gains are viewed as the quickest fif nor necessarily the surest) way t butll ‘one-thicd! capital. Young investors tend 1 favor growth-oriented and speculative vehi: cles, particularly high-risk common stocks, options, and futures.CHAPTER | market timing the process of identifying the cur- rent state of the economy/market ‘and assessing the Ukelinood of its ‘continuing on its present course. THE ROLE AND SCOPE OF INVESTMENTS. 1s jon stage of Ite ithe mide nal expenses and \s imvestors approach the middle-age consolid forties), family demands and responsibilities such as educa retirement contributions become more important. The whole portfolio goes through a transition to higher-quality secarities. Low-risk growth and income: stocks, preferred stocks, convertibles, high-grade bonds, and mutual funds are all widely used ac this stage. Finally, investors approach their retirement years. Preservation of capital and current income become the principal concerns. A secure, high level of income is paramount. Capital gains are viewed as merely a pleasant, occa- sional by-product of investing. The investment portfolio now becomes highly conservative. It now consists of low-risk income stocks, high-yielding govern ‘ment bonds, quality corporate bonds, bank certificates of deposit (CDs), and other short-term vehicles. As this stage, investors reap the rewards ota lifetime of saving and investing. Investing in Different Economic Environments Despite the governniencs arsenal of weapons for moderating economic swings, numerous changes are sure to occur in the economy during your life time of investing, At all stages of the life cycle, your iavestment prograin must be flexible enough to allow you co recognize and react to changing economic conditions, The first rule of investing 1s to know sehere to put yous money. The second is to know when to make your moves. ‘The first question is easier to deal with, because it involves matching risk and seturn objectives of your investment plan with the available invest- ment alternatives. For example, if you're a seasoned investor who can tolerate the risk, then speculative stocks may be right for you. If you're a novice who wants a fair eetuen on your capital, perhaps you shold consider a good growth-oriented mutual fund. Untortuaately, althoug's stocks and growth funds may do well when the economy is expanding, they can turn out to be disasters at other times. This leads to the second, and more difficult, question: ‘What effect do economic and market conditions have on investment returns? ‘The question of when to invest is difficult because it deals with market timing. The fact is that most economists and most professional money maa- agers—not to mention most investors—cannot consistently predict the peaks ‘and troughs in the economy or stock market. Its a lot easier to get a handle ‘on the current state of the economy/market, That is, knowing whether the economy/market is in a state of expansion or decline is considerably different from being able to pinpoint when it’s about to change course. Thus, for our purposes, we can define market timing as the process of identifying the current state of the economy/market and assessing the likeliiood of its continuing on its present course. As an investos it’s best to confine your assessment of the economy to three distinct conditions: (1) a state of recovery or expansion, (2) a state of decline oo recession, or (3) uncertainty as to the direction of its movement. These di ferent stages are illustrated in Figure 1.2. It’s easy to sce when things are moving up (recovery/expansion) and when the>'re moving down (decline/recession). The difficulty comes with the peaks and troughs. At those points, you don’t know shether the economy will continue in its current direc tion, up or down, or whether it will change direction. ‘That is why these areas in the figure are shaded, depicting enzcertainsty. How yor will respond ro these20 PART ONE ferent Stages of an Economic/Market Cycle The economic/market cycle shows three different conditions: (1) a state of recovery/expansion, (2) a state of dectine/recession, and (3) uncertainty as to the direction in which the ‘economy/market is going to mmave (shown by the shaded areas) SSTMENT ENVIRONAI THe Peak Uncertainty Expansion Dectine N Recovery Recession ‘Uncertainty \Sncartainty Trough Trough conditions depends on the types of investment vebicles you hold (for example, stocks or bonds). Stocks and the Business Cycle Common stocks and other equity-related securities (convertible securities, stock mutual furds, stock optians, and stock index futures) ate highly responsive to conditions in the economy. Econorvic conditions are described generically as the business cycle. The business cycle reflects the current status of @ variety of economic variables, including GDP (gross domestic product), industrial production, personai disposable income, the unemployment cate, and mote ‘A stiong economy is re‘iecied in an expanding business cycle. When busi- ness is good and profits sre up, stocks rexct by increasing in value and return. Growth-oriented and specuictice stocks tend ro do especially well in strong markets. To a lesser extent, so do low-risk and income-oriented stocks. In con- trast, when economic activity is declining, the values and returns on common stocks tend to be off as well. Bonds and Interest Rates Bonds and other forms of fixed-income securities, {preferred stocks and bond fnds) are highly sensitive to movernents in interest sates. In fact, interest rates are the single most important variable in deter- ‘nining bond price behavior and returns to investors. Interest rates and bond prices move in opposite directions {as will be explained in Chapters 9 and 10). Therefore, rising interest rates are unfavorable for bonds already held in an investor's portfolio. Of course, high Titerest rates enhance the attractiveness of new bonds berause these bonds must offer high ceturas to attract investors,ChAPTER Meeting Liquidity Needs: Investing in Short-Term j Vehicles tes siscount basis 4 method of earning interest on 2 ty by purchasing it at 2 jie below its redemption value: re iference isthe interest aed A relatively simple formule ean | THE ROLE AND SCOPE OF INVESTMENTS 21 As discussed would ensure that you have adequate liquidity. This provision is a prerequisite to implementing long-term investment goals Liguidity is the ability to convert an investment into cash quickly and with litele or no loss in value. A checking account is highly liquid. Stocks and bonds are not liquid, because there is no definite assurance that sou will be able to quickly sell them ar a price equal to or greater than their purchase price. The Role of Short-Term Vehictes Short-term vehicles are an important part of most savings and investment pro: grams. They generate income—which can be quite high during periods of high interest rates. However, their primary function is to provide a pool of resetves that can be used for emergencies or simply to accumulate funds for some spe cific purpose. As a rule of thumb, financial planners often suggest that any where from 3 to 6 months’ worth of after-tax income should be held in shore-term vebicles to raeet unexpected needs or to rake advantage of attrac tive oppectunities. Investors wsually hold short-term vehicles in their investment portfolios as a temporary, highly liquid investment until something better comes along, Some individuals choose to hold short-term vehicles because they simply are more comfortable with them. in fact, this approach has considerable merit during perivits of economic and investment instability. Regardless of your motives for holding short-term vehicles, vou should evaluate them ir. terms of their tisk and return, just as you would longer-term investments, Interest on Short-Term Investments Short-term investments earn interest in one of two ways. Soine investments, such 2s savins accounts, pay a stazed rate of interest. In this case, you can easily find the interest cate—it's the stated rate on the account, Alternatively, interest is earned on short-term investments on a discount basis. This means that the security is purchased at a price below its redemp- tion value, and the difference is the interest earned. U.S. Treasury bills (T-bills), for example, are issued on a discount basis. Risk Characteristics Short-term investments are generally considered low in risk, Their primary risk results from the loss of potential purchasing power that occurs when the rate of return on these investments falls short of the infla- tion rate. This has often been the case with such venicles as passbook savings ‘accounts, the traditional bank savings accounts that generally pay a low rate of interest and have no minimum balance, Over be applied long periods of time most other short-term investments have Uuhen interests eared en a discount Pasi 9 races of return that are about equal to, or maybe slightly higher ‘earning a stated rate of interest. ‘See this text's than, the average inflation rate. Web site for discussion of the formula, “The risk of default—nonpayment—is virtually nonexistent AAA with shore-rerm investment vehicles. The principal reason is that the primary issuers of most short-term vehicles are highly cep- utable institutions, such as the U.S. ‘Treasury, large banks, and major corpora tions. Deposits in commercial banks, savings and loans, savings banks, and credit unions also are insured for up t $100,000 pe account by government agencies. Finally, because the value of shore-term investments does not changeAAT ONE passbook savings account 2 savings account, ofered by banks, that generally pays a low rate of interest and has no min= imum balance NOW (negotiated order of with- ‘rawal) account 2 bank checking account that ays interest; has no legal mit {mum balance, but many banks jmpase their ow, money market deposit accounts (MMDAS) 2 bank deposit account with Lint ited checkewriting privileges: has no legal minimum balance, but many banks impose their own, THE INVESTMENT ENYIRON: anuch in sesponse co changing ineerese ates, exposure to capital loss is corre spondingly low: Advantages and Disadvantages of Short-Term Investments As noted, the major advantages of short-term investments are their high liquidity and low risk, Most are available from local financial institutions and can be readily converted 10 cash with minimal inconvenience. Finally, because the returns on ‘most short-term investments vary with inflation and market interest rates, investors can readily capture higher returns 2s rates move up. On the negative side, when interest rates go down, 1ecurns drop as well. ‘Although a decline in market rates has undesirable effects on most short- term vehicles, perhaps their biggest disadvantage is their relatively low return, Becauise these securities are generally so low in risk, you can expect the returns on. short-term investments to average less than the returns on long-terminvestments, Popular Short-Term Investment Vehicles Over the past 25 years or 0, the number of short-term investment vehicles being offered has greatly expanded. Investing in short-term securities is no longer the easy task it once was, when the decision for most people arnounted to whether to place funds in a passbook savings account or in U.S, savings bonds. Today; even some checking accounts pay interest on idle balances Along with the increase in investment alternatives has come greater sophisti cation in short-term investment management. Investors now know they can use short-term vehicles as secure investment outlets for the long haul or as a place to hold cash until they find a longer-term outlet for the funds. Tn the material chat follows, we will first examine the best-known short- term investment vehicles —depesit accounts, Series EE savings bonds, and U.S. Treasury bills. Next we will describe some ot the most popular nongovern- ment short-term securities. Finally, we will look at several ways to use these ent portfolio. deposits/securities in an investa Deposit Accounts Banks offer invcstors several forms of deposit aczounts that pay interest on account balances. (Note: We use the term bartk to refer to commercial banks, savings and loans (S8Ls), savings banks, and credit unions—al of which issue deposit accounts.) Four such accounts are passbook savings accounts, NOW {negotiated order of withdrawal) accounts, money ‘market deposit accounts (MMDAs), and asset management accounts. The dis- tinguishing features of these accounts are summarized in Table 1.3. The first two—passbook savings accounts and NOW accounts—are primarily used as savings vehicles. They provide the individual investor with a highly liquid pool of funds that can he accessed easily to meet scheduled as well as unexpected expenditures. The second two—MMDAs and asset maiiagement accounts— are mace likely t0 be used for investment purposes. For this use, they earn a reasonably competitive short-term return while maintaining sufficient liquidity to meet unexpected needs and seive attractive investment opportunities. Series EE Savings Bonds Series EE savings knows sa bonds that have been available for decades. You may have been given some by thrifty oF patriotic relatives on birthdays or other special occasions. (First issued in L941, these savings bunks useal to be called Series E bonds.)CHAPTER 1 ‘asset management account a comprehensive deposit account that combines checking, investing, and borrowing activi- ties: It automatically “sweeps” excess balances into short-term investments and borrows to meet shortages, Series EE savings bonds savings bonds issued by the U.S. Treasury and sold at banks and through payroll deduction plans, in varying denominations, at 50% of face value; pay a variable rate of intorest tied to U.S. Treasury securiy market yielis and calcu lated every sic months in May and November. accrust-type secunties securities for which interest is paid when the bond is cashed, on for before maturity, rather thas) periodically over the life of the bons. THE ROLE AND SCOPE OF INVESTMENTS 2% series BE bonds are acerual-type securities. This meany that interests pai when che bond is cashed, on or before maturity, rather thap periodically over the life of the bond. They are sold at a discount—the purchase price of all denominations is 50% of the face value. Thus a $100 bond costs $50 and will be worth $100 at maturity. Series EE bonds are backed by the full faith and credit of the U.S. government. They can he replaced withou charge in case of toss, theft, or destruction. They can be purchased at hanks or other thrife nsti- tutions of cheough payroil deduction plans. They are issued in denominations of $50 through $10,000. A person is limited to maximum annual Series EE bond purchases of $15,000 (i.e., $30,000 face value). ‘The actual maturity date on EE. bonds is unspecified because they pay a variable rate of interest. The higher the rate of interest being paid, the shorter the period of time it takes for the bond to acerue from its discounted purchase price to its face value. The rate of interest paid on EE bonds is 90% of the average 5-year Treasury security market yields for the preceding 6 months. Bonds can be zedeemed any time after the first 6 months. All EE bonds held from 6 months to 5 yearsare penalized by forfeitivg the last 3 months of interest earned. The US. Treasury calculates taterest rates every 6 months (in May and November}, Interest rates change in accordance with prevailing ‘Treasury security market yields. You ean obtain current rates on Series EE. bonds from your bank or simply by calling 800-487-2663. (Note: For bonds purchased after May 1, 1997, the rate for the 6-month period ending Occober 31. 2001, was 4.50%. } Interest is credited every 6 months and compounds semiannually 4 Fe ‘Type of Account Brief Description Minimum Balance “Interast Rate Insurance Passbook savings Savings accounts offered by banks. Typically none 2%-6% Yes, up (0 ‘account Used primarily for convenience or if depending {$100,000 per investors lack sufici funds for fon economy deposit. other short-term vehicles. NOW inegotiated Bank checking account that pays No legal minimum, At or near Yes, up to ‘order of withdrawal) interest on balances. but often set at passbook $100,000 per ‘account '$500 to $1,000 rates ‘deposit. Money market ‘Bank deposit account with limited No legal minimum, Typically Yes, up to ‘deposit account chedwriting privileges. but often set at about 1% above $190,000 per imma) about $2,500 assbook rate deposit, ‘Asset management Deposit account at bank brokerage Typically $5,000 —SimlartoMMDAs Yes, upto ‘account house, mutual fund, or insurance to $20,000 {$109,000 per ‘company that combines checking, deposit in Investing, and borrowing. Auto- banks. V ‘matically “sweeps” excess balances in other into short-term investments and insttutions borrows to meet shortages. ‘Tho torm bonk refrs to commercial hanks, savings and loans (SLs savings banks, and credit unionsPART ON U.S. Treasury bills (T-bills) lligations of ths U.S. Treasury, sold on 2 discount basts, and having varying short-term matus fies: regarded as the safest of all investnients. THE INVESTMENT EY in addition to being escnipe trom stare and local tases, Series EE bonds provide an appealing tax twist: luvestors need not report the interest earned ton their federal tax returns until the bonds are redeemed. Interest can be teported annually. This might be done, for example, if the bonds are hetd én. the name of a child who has limited interest income. But most investors choose to defer reporting the interest. In effect, this means the funds are being reinvested at an after-tax rate equal to the bond's current interest rate. Another attractive tax feature allows partial or complete tax avoidance of EE bond earnings when proceeds are used t0 pay education expenses (such as col: lege tuition) for the bond purchaser, a spouse, or other IRS-defined depen dent. To qualify the purchaser mast be age 24 or older and must, after December 31, 1999, have adjusted gross income below $54,100 for single filers and $81,100 for married couples. (The maximum income levels are adjusted annually.) The U.S. government also issues Series HH and Series I savings bonds. Both are issued at face value. The HH bonds pay interest twice a year. The I bonds, which are inflation-indexed, pay accrued interest at the bond’s matu- «ity, which is 30 years USS, Treasury Bills U.S. Treasury bilis (T-bills) are obligations of the U.S. Treasury issued as past of its ongoing process of funding the national debt. Thills are sold on @ discount basis in minimum: denomirations of $1,000 and are issued with 3-month and 6-month maturities. The U.S. Treasury auctions off the 3- and 6-monch bills every Monday. Purchasing T-Bills You can purchase Thills directly, through participation in che weekly Treasury auctions. Or you can purchase them indirectly, through local commercial banks, secutities dealers, or brokers who buy bills for investors on a commission ‘asis. You can direesly purchase T-bills over the Internet (www.publicdebt.t.eas.gov) or by using a touch-tone phone (call Treasury Direct Electronic Se-vices at 800-722-2678 and follow the interactive menu to complete transactions). You also can purchase outstanding Treasury bills in the resale marker through banks or brokers. The biggest advantage of the resale market is that you have a much wider selection of maturities to choose from, ranging from less than a week to as long as 6 months. tis relatively simple to buy T-bills directly, All you need o do is submit a tender offer (0 the nearest Federal Reserve Bank or branch, specifying both the amount and the maturity of T-ills desired. (Tender forms can be obtained by writing the Bureau of the Public Debt, Department N, Washingtoa, DC 20239-1500, or by calling 202-622-2600.) The Treasucy tries to accommo- date individual investors ckrough its noncompetitive bidding system, which most people use because ofits simplicity. In essence, all noncompetitive tender offers (by rmal. over the Incerner, and by phone} are awarded T-bills at a price equal to the average of all the accepted competitive bids. Thus you are assured of buying bills in che quantity desired, while obtaining the benefits of an open auction system—all without going through the hassle of a competi tive bid. Note, though, chat T-ills bought directly through noncompetitive bidding are meant to be held co maturity. You should not puschase T-bills by noncompetitive bid if you want to trade thom, It is difficult and time consuming to sell these T-bills iu the aftermarketCHAPTER 1 ‘A specialized formula can be used to calculate —_Yicldit the yields on bills. See this text's Web-site for econ diseussion of the formula, THE ROLE AND SCOPE OF INVESTMENTS 28 Evaluating TBills & particularly seesstive tomar of Tholtsis thar thes are exempt from state and local income taxes, which in some areas ean be as high as 20%, Federal taxes are not due until the interest is actually received at maturity, Also, because they are issued by rhe U.S. Treasury, Toills are regarded as the safest, though generally the lowest- of all investments. Furthermore, rere is a highly active ry market for Treasury bills (other than those bought through noncompetitive bidding), so you can easily sell chen if you need the cash certificates of deposit (CDs) savings instruments 1m which funds mst remain on deposit fo 2 specified period; withdrawals prior to maturity incur interest renalties. rokered CDs rtificates of deposit sold by Stockbrokers; offer slightly higher Yields than other COs and typi- ‘ally can be sold prior to maturity without incurring a penalty ‘commercial paper short-term, unsecured promissory notes (L0US) issued by corpora- tions with very high creai standings Nongovernment Short-Term Securities We have seon thar you can use éeposit accounts, Series EE savings bonds, and U.S. Treasury’ bills to meet lig uidity needs. You can also meet liquidity needs by using nongovernment short term securities. These securities generally tend to have higher yields than deposit accounts, EE bonds, and T-bills with similar maturities due to the slightly higher risk associated with them. Th principal nongovernment mar erable securities include certificates of deposit, commercial paper, banker's acceptances, and money market mutual funds. Each is briefly described below Certificates of Deposit Certificates of deposit (CDs) differ from the deposit accounts discussed above i: that funds mi con deposit for a specified period. This period can range from 7 days to a ye Tehongh Tes possible to wathdraw tunds prior to matunty, an interest penalty (equal to 31 to 90 davs of interest) usually raakes withdrawal costly. Banks today are free securities. The interest rate on CDs is to offer any rate and maturity on the fixed over their stated maturity. _ ‘CDs ate convenient to buy and hold, and all offer attractive and highly competitive returns plus federal insurance protection (up to $190,000 per deposit). The decision whether ro invest in a CD or in a more liquid short-term investment vehicle (such as a MMDA or a Tbill) generally depends on the length of the holding period and interest rate expectations. Uncertain holding periods and expected interest rate increases would favor MMDAs and T-bills; certain holding periods and expected interest rate declines would favor CDs. ‘CDs can also be purchased from stockbrokers, in the form of brokered CDs. The brokerage house looks around the country for the highest yield it can get, buys these CDs, and then resells them to its clients. In essence, a bank issues the CDs, and the brokerage house places them with the investing public. There's usually no commission to pay, because the broker earns its commission from the issuing bank. The minimum deromination is usually $1,000. Brokered CDs are attractive for two reasons: (1) They can be sold_prior to ‘maturity without incurring a penalty. (2) They may provide higher yields—i quently % to ¥ of a percent higher—than those available from a loca bank. Commercial Paper Commercial paper is short-term, unsecured promissory ‘notes (JOUs) issued by corporations with very high credit standings. Most com- mercial paper is initially sold in multiples of $109,000. Typical maturities range from a few days up to 270 days, the maximum maturity that does not require registration with the Securities and Exchange Commission (SEC). Because the resale market for commercial paper is limited, most investors hold commercialee PARL ONE banker's acceptances short-term, low-risk investment vehicles arising from bank guar- antees of business transactions! ate sold at a discount from their face value and generally provide ied slightly below those of CDs and commercial paper money market mutual fund (HME) 2 reutual una that pools and uses it to Invest excl in high-yielding, short-term securities, THE INVESTMENT ENyinuten paper €o maturity [ty ie i comparable co the rate of return earned on large denomination CDs. Most individual investors who obtain commercial paper lo so trom a bank or broker, who will “break down” the paper and sell the investor a small portion. However, returns on commercial paper are generally comparable to returns on CDs, which have a fixed maturity like commercial paper but in addition also have federal insurance protection. Banker's Acceptances Banker's acceptances arise from short-term credit arrangements used by business tirms co finance transactions. Most often these involve fiems in foreign countries or with unknown credit capacities. Typically, an importer’s bank agrees to pay its forcign supplier on behalf of the importer, who is contractually obligated to repay the bank within the 3 © 6 months ir takes to receive and sell the merchandise involved in the teansaction. The importer’s bank may either hold the acceptance to maturity or sell it at a dis- count to obtain immediate cash. An investor who buys a banker's acceptance is therefore promised payment of its face value by the importer at the specified future date, As a result of its sale, the banker’s accepzance becomes a mar- The initial maturities of banker's acceptances are typically between 30 and 186 days, 90 days being most Hf the importer fails t0 pay the amount due at maturity, the bank is Hable for the payment. Because of this, banker’s acceptances, which eypically have a minimum denomination ef $100,000, are low-risk securities with good resale 1: The yields on banker's xccep tances are generally slightly below those of CDs and commercial paper; they can usually be puschased through a bank or stockbroker Money Market Mutual Funds & money market mutual fund (MMMF) is a mutual fund that pools the capital of a iarye number of investors and uses it to invest exclusively im higl-yielding, shor:-term securities, such as Treasmy hills, iarge certificates of de>osit, and commercial paper. Because such securi- ties are sold in denominations of $1,000 to $1 niillion (or more), most small investors cannot purchase them individually. The MMMF makes these vehi- cies, which very often offer the highest short-term returns, available to even small investors, Shares of MMMFs can be purchased through broke:s or directly from the fund in initial amounts as small as $500 to $1,000. MMM provide easy access to funds through check-writing privileges. You continue to earn interest while the check is being cleared through the banking system. Almose every major brokerage firm kas a money fund of its own; hundreds more are unaffiliated with a specific Brokerage firm. The returns on money funds amount to what fund managers are able to carn from their investmect activity in variows short-term securities. Thus, the returns rise and fall with money market interest rates. Though they are not federally insured, MMMFs have very low risk because the securities they hold are very low in risk and diversitication by the funds lowers risk even more (More information about the features and types of MMMES is included as part of the discussion of mutual funds in Chapter (2.} Investment Suitabitity Individual investors use short-term vehicles for bori savings and investment. ‘They use short-term vehicles to maintain a desired level of savings that will beHAPTER 1 THE ROLE AND SCOPE OF INVESTMENTS a7 readily available if the need arises—iat essence, to provide safety and security For this purpose, high yield is less important than safety. liquidity, and conve rience. Passbook savings accounts, NOW accounts, and Series FE savings bonds are the mos¢ popular savings vehicles When short-term vehicles are used for investment purposes, yield is often just as important as liquidity. However, because the objective is different, the short-rerm vehicles tend to be used much more aggressively. Most investors will holdat least a part of theie portfolio in short-term, higaly liguid securities, if for rno other reason than to be able toact on unanticipated investment opportunities. Some investors, in fact, devote all or most oftheir poctfolios to such securities. One of the most common uses of short-term securities as investment vehi cies is as temporary outlets. In that use, investors buy short-term vehicles either to warehouse funds antil an attzactive permanent investment can be found or ro sic on the sidelines in times of unsettled or undesirable marker con- ditions. For example, if you have just sold some stock but do not have a snit able long-term investment alternative, you might place the proceeds in 2 money fund until you find a longer-tern use for them. Or if you feel that interest rates are abou: to rise sharply, you might sell your Ioag.terma bonds and use the proceeds to buy Tbills. ‘The high-yielding securities—like MMDAs, CDs, commercial paper, banker's accepeances, and money funds— are generally preferred for use as part of am investment program, as are asset ‘management accounts at majer brokerage firms. To decide which securities are most appropriate for a particular situation, you need to consider such issue characteristics as availability safety, liquidity, and yieid. Though ail the investments we have discussed satisfy the basic liquidity demand, they do so to vayying degrees. A NOW account is unquestionably the most liquid of all. You can write as many checks on the account as you wish and for any amount. A certificate of deposis, an the other hhand, is not so liquid, because early redemption involves 2a interest penalty Savings or Passbook savings account (0%) NOW account F (05% ‘Money market deposit account (MMA 8 Ae A 8. (4.0%) ‘Assot management account BOA Ae B (5.0%) Series EE savings bond Ae hee Be (5.7%) US. Treasury bill (91-day) BAe Aq (6.0%) Conificate of deposit (Gmonth,large denomination) «8B ae c A (86%) Commercial paper (90-day) 8 a c A. 16.5%) Banker's acceptance (90-day) BOA 8 A (86%) Money market mutual fund (MNIMES 8 WAL Be Ax 18.0%) ‘Tha everaae rates reflect epreszatative oF types ratue that asta nite 000,Table 1-4 summarizes the key charaeseristies for most of the short-term investments discussed here. The letter grade assigned Get the latest Treasury securities data on 20. For cack characteristic reflects an estimate of che investment’s year bonds, 10-year notes, 5-ye "S.weet bills. Visitahoo! Finan USS Markets, [major U.S. Indices], 0 get the most eurvent quote (ast tradel, the change imum amount of $: notes: and quality in that area. For example, MMMEs rate only a Br on sger liquidity, because withdrawals must usually be made in a min- to $500, NOW accounts are somewhat from the previous trading day, the pereent send ene eee fee eee change, dvert, news, and much more, better in this respect, b hdrawal can be for any amount. Yields are self-explanatory. You should note, though, ifs investonent scores lower on availabliy, safety or lige uidity, it will genevally offer a higher yield Summary ate: The end-of-cnapter Summaries restate the chapters Learning Goals and review the key points of information related to each goal. lee} te? tes tes ‘Undecstand the meaning of the term investment and the factors commonly used to dif- fecentiate among types of investments. An investment is any vehicle into which funds cean be placed with the expectation thac they will generate positive income andlor that their value will be preserved or will incecase, The returns from investing aze received either as current income or as increased value Some investment vehicles are securities: others are forms of property. Some invest ments are made dicectly, others indicectly. An investment can be a debt, am equity, or a derivative security such as an option. I: can possess risk canging from very low to exteemely high. An individual can invest its either short-term or long-term vehicles Today, individual investors have ready access vo boiks domestic and foreign invesuments. Describe the investment process and types of investors. The investment proces is steuc- tuted around financial instiacions and financial markets that bring together supplices and demandets of funds. The dominant financial market in the United States is the secu- fits markets or stocks bonds. ad options. The participants in the invesiment process are government, business, ao inaividvals. OF these Groups, oniy individuals are ict, suppliers of funds. Investors cas be either individuah mevestors or institutional investors Discuss the principal iypes of investment vehicles, A broad range of investment vehi- cies is available. Short-terin vehicles have low cisk, They are used to earn a return on temporarily idle fund:, to serve as a primary investment outlet of conservative Investors, and to provide liquidity. Common stocks ofter dividends and capital gains. Fixed-income securities—bonds, prefersed stock, and convertible securities—offer fixed periodic retuens with some potential for gain in value. Mutual funds allow investors conveniently to buy of sell ineerests in a professionally managed, diversified potifolio of securities. Derivative securities are high-risk, high-expected-return vehicles, The key deriva Lives are options and futures. Options offer the investor an opportunity to buy or sell another secutity at specified price over 2 given petiod of time, Futures are contracts berweon a seller and a buyer for delivery of a specified commodity or financial instru rent, at a specified furure date, at an agreed-on price. Other poplar investment vehi cangybles, and tax-advantaged investments cles include real e Describe the steps in investing, particulacly eszabiishing investment goals, and cite fun- damental personal tax considerations. Investing is a process that should be driven hy well-developed plans established to achieve specific goals, It involves a logical set of steps: meeting investment prercquisites, establishiRg investment goals, adopting an investment plan, evaluating investment vhicks, selecting suitable investments, con- structing a diversitiad portiotin, anu! manguing the portotio. avesement goals deterCHAPTER 1 ay THE ROLE AND SCOPE OF INVESTMENTS 29 mine the types of investments made, Common investment goals include accumularing retirement funds, enhancing current income, saving for major expenditures, and shel: tering income from taxes, The tax consequences associated with various investment vehicles and strategies must also be considered, The key dimensions are ordinary income, capital gains and losses, and eax plant over the life eyce and investing indifferent economic environments ‘ehicls selected are affected by the investors stage inthe ‘fe cycle and Younger investors tend to preter growth-oriented investments that stress capital gains. As they age investors move to higher-quality securities. As they Spproach retirement they become even more couss-vative. The stage of the economy— (1) recovery of expansion, (2) decline o:recessior, o (3) uncertainty a8 to direction of ‘movement —both curtent and expected, also affects investmene choice, Understand the popular types of short-term investment vehicles, Investment plans must ‘ensure adequate liquidity. Liquidity needs can be met by investing in various short-term vehicles, which can earn interest at a stard rare or on a discount basis. They typically hhave low risk, Nuruerous shor went vehicles are available from Benks, the ‘government, and brokerage firms, Their suitability depends on the investor’ atvirude toward availability, safery. liquidity, and yield.Od 0 er de S000) MARKETS AND SETS Learning Goals 7 eT should be able to: ic: Mr ee rater Pere ard et ence et Perce terae eens ee eee pérfarmance; aiid the Twestment. Seer ee eee en ee Lc 5 MoE Prcreciea Sec rhe Paris, Amsterdam, and Brussels stock exchanges merge to form Euronext, a larger cross-border stock exchange. The ‘Scandinavian exchanges do the same, creating Norex. Competitive pressures bombard the venerable New York Stack Exchange (NYSE), whose cumbersome auction system has lost significant market share to Nasdaq's electronic trading system, home to most technology stocks. Upstart electronic communications networks (ECNs) that match buyers and sellers grab trades away from Nasdaq. Welcome to the changing world of securities markets, where national boundaries are losing importance. Thanks to advances in telecommunications, networks of electronic seréens replace the traditional stock exchange trading floor. Somie ‘ridustry observers envision the creation of a centralized “World Stock Exchange,” an electronic marketplace that follows the sun, trading in issues listed on any recognized stock exchange. Ushers predict that three of fou world markets sill emerge. Opponents of such immense’ multinational exchanges ce scessary Investors can already buy in. London and sellin Hong Kong through online or traditional brakes. They worry that fewer securities markets will reduce competition, They also cite the very diferent national regulations as a major stumbling block to successful market consctidatio: Jin this chapter, e will study the markets, the exchanges, the regulations, and the cransactions that enable companies to raise money in the capital markets and enable institutions and individuals to invest in these companies,HAPTER 2 Securities Markets ter] [ee2] [ies securities markets forums that alow supplies and demanders of securities to make Financial transactions; they Include both the money market and the copitol market money market im which short: Securities are bought and sold ital masket et inuhich long-term Securities such as stocks amd bonds ae bought and sold primary market the market in which new i:sues 9F securities are sold to the pubbe. initial public offering (IPO) the First public sale of a sompaay/s stock. securities and Exchange fommission (SEC) federal agency that regulates Eecurities offerings and markets ublic offering sale af a firn’s securities to 1e generat public. Hiahts offering an offer of new shares of stack to existing stockholders on a pro ‘ata basis. private placement the sale of new securities drect'y to selected groups of investors. without SEC registration. The SEC site, in addition to providing co:po rate documents such as annual repors, offers basic information and warnings ta new sale oft NWESTMENT MARKETS AND TRANSACTIONS 3 Securities markets are forums that allow suppliers and demanders of securities to make financial transactions, They peemit such transactions to be made quickly and at a fair price. In this section we will look at the various types of markets, their organization, and theie general behavior Types of Securities Markets Securities markets may be classified as either money markets or capital mar \eets. The money market focuses on the purchase and sale of short-term secu: rities. Investors turn to the capital market for transactions involving long-term securities such as stocks and bonds. tn this book we wil! devote most of our attention to the capital market. There, investors can make stock, bond, mutual fond, options, and futures cransactions. Capital markets can be classified as either primary or secondary; depending on whether securities are being sold initially by their issuing company or by intervening owners, The Primary Market The market in which mew issues of sccurivies are sold t0 the public is the primary market. In the primary market, the issuer of the equity or debt securities receives the proceeds of sales. In 2000, 452 compa- nies offered their stock for sale in the primary market. The main vehicle in the primacy markct is the initial public offering (IPO), the first public sale of a company’s stock. The primary markets also sell new securities, called seasoned new issues, tor companies that are already public. Before offering its securities for public sale, the issuer must register thein with and obtain approval from the Securities and Exchange Commission (SEC). This federal regulatory agency must confirm both the adequaty and che accurac} of the information provicled to potential investors Before A security S publicly offered for sale, In addirion, the SEC regulates the securities markets. ~'To marker its securities in the primary market, a firm has three choices. It may make (1) a public offering, in which the firm offers its securities for sale to the general public; (2) a rights in which the firm offers new shares to existing stockholders. on a pro rata basis; or (3) a private placement, in which the firm sells” new securities directly, without SEC registration, to selected groups of investors such as insurance companies and pension funds. Going Public: The IPO Process Most companies that go public are small, fast-growing companies that require additional capital to continue expanding, For example, biotechnology company Orchid Biosciences raised almost $48 million when it went public in May 2000 at $8 per share. In addition, large companies may decide to spin off a unit into a separate public corporation. AT&T did this when it spun off its wireless operations into AT&T Wireless in April 2000, raising over $10 billion at $29.50 per share. When a company decides to go public, it fiest must obtain the approval of its current sharcholders, the investors who own its privately issued stock. Next, the company’s auditors and lawyers must certify that all docu- _ments for the conspeity are legitimate. The company then finds an investment bank willing to underwrite the offering: This under writer is responsible for promoting the stock and Facilitating tne company’s IPO shares. The underwriter often bringsin ment benking firms 2s participants. We'll diseuss the other inves role of the investment banker in more detail in the next section.sz PRAT ONE — THE INVESTMENT ENVIRONMENT WoT The company’ files « eeyiseration statement with the SEC One portion of the registration statement is called the Read a fourpart series on IPOs at the CBS site prospectus. It describes the key aspects of the issue, the issuer, Byseoling down tte page and ctexing more Phe h wens ment and financlal po tools and data} and [IPO basics. Aiso,"to find fan IPO index, go to the edgar si . During the waiting period between the statement’ filing and its approval, prospec- tive investors ean receive a preliminary prospectus. This prelim: AMIS inary version is called a red herring, because a notice printed in ted on the front cover indicates the tentative nacure of the oes. The cover of the preliminary prospectus describing the 2001 stock issue of Reliant Resources, lnc. is shown in Figure 2.1. Note the red her- prospectus ring printed vertically on its left edge. 4 portion of a security After the SEC approves the registration statement, the investment commu- registration statement that ty can be ieee A ects, Hi from th nity can begin analyzing the company’s prospects. However, from the time it eseribes the Key aspects of he les until at least one month after the IPO is complete, the company must {ssve, the issuer, and its ranagement and financial observe a quiet period, during which there are restrictions on what company ae officials may say about the company. The purpose of the quiet period is to make sure that all potential investors have access to the same information about the ied herring company—that which is presented in the preliminary prospecyss—and not to A oveliminary prospectus made any tmpublished data that might give them an unfair advantage. vallable 10 prospective investors uring the waiting period ‘The investment bankers and company executives promote the company’s Between the registration stock offering through a road show. a series of presentations to potential Ruuteniet’s Bling with the SEC investors around the cownecy and sometimes everseas. In addition to providing dnd its approval. investors with information abows the new issue, road show sessions help the investment bankers gauge the demand for the offering anc set an expected pricing range. After the underwriter sees terms and prices the issue, the SEC ppprove the offering, Table 2.1 shows the offering date and price, first-day gain, and revurn based om the price on Avgist 31, 2000, for selected IPOs. Nuznce alas aepee aay hot Communications’ offering pri doubled on the first day and continued re rise. inrecgnt ese In 2000, 452 Often the investment banker adjusts the IPO offering price if demand seems rewiypuble US. companies very high or low. For examp'e, the preliminary offering price range for the cade ete ioe America Online Latin America IPO was $15-$17. Because of lukewarm nae vee ee ity es. investor reaction, the investment hanker dropped the offecing pric? to $8. The reaecas Geedefrts yay’; OPPosite may also be crue In ecent years many IPO deals have been under- rane HRA priced, resulting in huge first-day gains, Some industry experts question whether the underwriters misjudge demand for the issue or set the price arti cially low to please their institutional clients, who buy at the offering price and then resell the shares. Sometimes companies themselves support undervalua- tion so that their stock will generate excitement and addisional Log on to individualinvestor.com end cfc: The IPO snarkers have been particularly active in recent [eduestion|, how to road), [A Prospectus} years. Such activity has been a direct resalt of the strength of the public equity markets. However, investing in IPOs is cisky busi- ness, particularly for individual investors who can't casily acquire shares at the offering price Most of those shares go to institutional investors and brokerage firms’ best clients. Although many news stories chron- icle huge first-day gains, the stocks may not be good long-term investments, In {investment banker the Investing in Action box on page 35 you will learn more about the perils and eae wn oe rewards of IPO investments. ‘aus end advising firms with . eee oN aajor Femecla The Investment Banker's Role Most public offerings are made with the vs. assistance of an investment banker. The investment banker is a financialHAPTER 2 INVESTMENT MARKETS AND TRANS; Cover of a Preliminary Prospectus for a Stock Issue Some of the hey factors related tw the 2001 common stock insue by Reliant Resources, Inc. are summarized on the cover of the prospectus. The type printed vertically on the left edge is normally ed, which explains its nape “ed herring.” (Source: Reliant Resources, Tne., April 16, 2001, p. 1.) 152,000,000 Shares Reliant Resources, Inc. Common Stock 74 $2.00 90 sare at som took we Ba Say hat vow, ir fo i fle, ar haste 9 pe maa lr he come nk cure vrata hat ol pase otra bars st ott Suto wn 8. uno satts en tree Ergon ahi Yor So Cerne dre 3g Syron"ARI” wopct to ote monce tahun [an cr p11 rad ato 98 ak atone ae tte Sees un Exchange Common ra any error er Ma approved unpre shane section or pened apa he sonny oosegcy ot ‘orcas: Any repeara nse conrey te car ofene. Goldman, Sachs & Co. Credit Suisse First Boston ‘ABN AMRO Rothschild LLC Banc of America Securities LLC : Deutsche Banc Alex. Brown Merrill Lynch & Co. UBS Warburg FABLE Zc performance of Siected 1P0s Return 10 Po Current {IPO price Offering Offering First Day Price to current Company Name Date Price Gain 8/31/00) price) Vignene 27889 $19.00 187% $08.19 100.7% FlashNet Communications an69 1700 158.6 378 719 ‘Skechers USA 61999 n00 34 var a19 Arriba 6722199 23.00 2813 15738 5843 7124 Solutions 127100 26.00 1762 46.88 80.3 Antigenics 213/00 18.00 2810 1556 Buy.son: 27100 13.00 933 269 Homegrocer.com 9100 12.00 18 406, Nuanee Communications an200 1200 998 13163 Orchid Biosciences 5/4/00 8.00 368 43.00 ‘Source-“iniis Pubite Offerings, Top te Bottom Wal Street Journal January 32000, p. Re, anc IPOhOMe www ThelPOsite com34 AAT ONE Fasiieee The Selling Process for ‘a Large Security Issue The investment banker hired by the issuing corperation may form an underwriting syndicate, The underwriting syndicate buys the entire security issue from the issuing corporation at an agreed-on price. The underuriter then has the opportunity {and bears the risk) of reselling the issue to the public at a profit Both the originating investment banker and the other syndicate members gut together a selling sroup to sell the issue on a Commission basis to investors. underwriting tho rale ef the investment banker in bearing the risk of reeling, at «4 prof, the secuntios purchase from an issuing corporation at {an agreed-on price. underwriting syndicate 3 group Formed by an investment banker to share the financial sh asiociated with underwnting new securities. selling group 4 imge number of brokerage firms that join the originating investment banker(s); each accepts responsibility for selling 2 certain portion of a new security issue CCheck out some leading investment banks, such as THE INVESTMENT ENVIRONMEN Underwriting Syndicate Tavestrient Bankor Bis: Selting Group Pri ted J O06 200 66 Ad a a a intermediary (such as Salomon Brothers or Goldman Sachs) that specializes in selling new security issues and advising firms with regard to major financial transactions. The main activity of the investment banker is underwriting. This, process involves purchasing the security issue trom ing corporation at an agreed-on price and bearing the risk of reselling ic ‘0 the public at « profi ‘The investment banker also pro ides te ing and important aspects of the issue. In the case of very large sec ity issues, the investment banker brings in other bankers as pariners 10 forin an underwriting syndicate. The syndicate aces the financial risk associated with buying the entire issue from the issuer and reselling the new securities ro the public. The originating investment banker and the syndicate members put together a selling group, normally made up of themselves and a large number of brokerage firms. Each member of the selling group accepts the responsibility for selling a certain portion of the issue and is paid a commission on the securities it sells. The selling process for a large security issue is depicted in Figure 2.2. The relationships among the participants in this process can alse be seen in the so-called tombstone for the June 27, 2000, common stock offering for Com- munity Health Systems, Inc. shown in Figure 6.4 (on page 177). This layout of the announcement indicates the roles of che various participating firms. Isolated firm names or a larger typeface ditterenciates the underwriter and the under- writing syndicate from the selling group. (In the figure, the key participants in the offering are labeled in the margin at the lef.) Compensation for underwriting and selling services typi- cally comes in the form of a discount on the sale price of tive securities. For example, an investment banker may pay the issuing fiem $24 per share for stock that will be sotd for $26 per shase. The investment banker may then sell the shares «0 mem bers of sz