Download Traditional Investment Alternatives (cont`d)

Chapter
Twenty-One
Understanding
Personal Finances
and Investments
Learning Objectives
1. Explain why you should manage your personal
finances and develop a personal investment
program.
2. Describe how the factors of safety, risk, income,
growth, and liquidity affect your investment
decisions.
3. Understand how securities are bought and sold.
4. Identify the advantages and disadvantages of
savings accounts, bonds, stocks, mutual funds, and
real estate.
5. Describe high-risk investment techniques.
6. Use financial information to evaluate investment
alternatives.
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Preparing for an Investment Program
• Managing Your Personal Finances
– The use of your personal funds to earn a
financial return
• Investment goals
– Personal investment goals must be
•
•
•
•
Specific and measurable
Tailored to individual needs
Focused on the future
Realistic in terms of economic conditions and
opportunities
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Preparing for an Investment Program
(cont’d)
• Questions to consider when establishing goals
– What financial goals do you want to achieve?
– How much money will you need, and when?
– What will you use the money for?
– Is it reasonable to assume that you can obtain the
amount of money you will need to meet your
investment goals?
– Do you expect your personal situation to change in
a way that will affect your investment goals?
– What economic conditions could alter your
investment goals?
– Are you willing to make the necessary sacrifices to
ensure that your investment goals are met?
– What are the consequences of not obtaining your
investment goals?
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Preparing for an Investment Program
(cont’d)
• A personal investment program
– Involves a careful evaluation of different
investment opportunities
– Financial planner
• An individual who has had at
least two years of training in
investments, insurance, taxation, retirement
planning, and estate planning and has passed
a rigorous examination
– Begin by accumulating an emergency fund
– Invest funds according to your plan
– Monitor the plan
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Preparing for an Investment Program
(cont’d)
• Suggestions to help you accumulate the
money needed to fund an investment plan
– Learn to balance your budget
– Make savings a higher priority
– Take advantage of employer-sponsored
retirement programs
– Participate in an elective savings program
– Make a special savings effort one or two
months each year
– Take advantage of gifts, inheritances, and
windfalls
Source: Jack R. Kapoor, Les R. Dlabay, and Robert J. Hughes, Personal Finance, 7th ed. (Burr Ridge, IL: Irwin-McGraw Hill, 2004), p. 421.
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Important Factors in Personal
Investment
• Match potential investments with your goals in terms
of several factors
– Safety and risk
• Minimizing the risk of loss (e.g., investing in blue-chip
stocks)
• Maximizing potential returns by assuming some risk
– Investment income
• Predictable interest and dividends from stable
investments (e.g., certificates of deposit, corporate and
government bonds, and certain stocks)
– Investment growth
• An increase in the value of an investment, such as
mutual funds and real estate that appreciate in value
– Investment liquidity
• The ease with which an investment can be converted
into cash
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How Securities Are Bought and Sold
• Securities are usually exchanged with the help of an
account executive or stockbroker
• The primary market
– A market in which an investor purchases financial
securities (via an investment bank) directly from the
issuer of those securities
• Investment banking firm—an organization that assists
corporations in raising funds, usually by helping sell new
issues of stocks, bonds, or other financial securities
• High-risk investment—an investment (e.g., an IPO)
made in the uncertain hope of earning a relatively large
profit in a short time
• Institutional investors—pension funds, insurance
companies, mutual funds, banks, and other organizations
that trade large quantities of securities
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How Securities Are Bought and Sold
(cont’d)
• The secondary market
– A market for existing financial securities that are
traded between investors
– Securities exchange—a marketplace where member
brokers meet to buy and sell securities
• New York Stock Exchange (NYSE), American Stock
Exchange, regional exchanges, foreign exchanges
– Over-the-counter (OTC) market—a network of dealers
who buy and sell the stocks of corporations that are not
listed on a securities exchange
• Nasdaq—computerized electronic exchange system
through which most over-the-counter stocks are traded
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Criteria a Firm Must Meet Before Being
Listed on the NYSE
Source: New York Stock Exchange, www.nyse.com, February 9, 2003.
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How Securities Are Bought and Sold
(cont’d)
• The role of an account executive
– An individual, sometimes
called a stockbroker or
registered representative,
who buys and sells securities
for clients
• Full-service broker—provides
personal investment advice and
other market and investing
information
• Discount broker—simply executes
buy and sell orders for lower
commissions than a full-service
broker; does not offer advice
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Steps in a Typical Stock Transaction
on the NYSE
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How Securities Are
Bought and Sold (cont’d)
• The mechanics of a transaction
– Market order
• A request that a security be purchased or sold
at the current market price
– Limit order
• A request that a security be bought or sold at a
price that is equal to or better than some
specified price
– Discretionary order
• An order to buy or sell a security that lets the
broker decide when to execute the transaction
and at what price
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How Securities Are
Bought and Sold (cont’d)
• Online security transactions
– Software can help investors evaluate
potential investments, manage
investments, monitor value, and place
buy and sell orders online
– Investors must still analyze the
information and make decisions
– Online trading generally has lower costs
– Program trading—a computer-driven
program that monitors the market value
of particular stocks and enters buy or
sell orders when those stocks reach
specified prices
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How Securities Are
Bought and Sold (cont’d)
• Commissions
– Most brokerage firms have a minimum commission
– Additional commission charges are based on the
number of shares and the value of stock bought and
sold
– Full-service brokerages charge a percentage of the
transaction amount (as much as 1.5 to 2.0%)
– Discount brokers charge lower commissions or a fixed
fee amount per transaction
– Commissions for bonds, commodities, and options are
lower than for stocks
– Round lot—a unit of 100 shares of a particular stock
– Odd lot—fewer than 100 shares of a particular stock
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Typical Commission Costs
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Regulation of Securities Trading
• State regulation
– States require registration of stock issues and licensing
of brokers and securities dealers
• Federal regulation
– Securities Act of 1933 (Truth in Securities Act)
• Requires registration statement about the corporation
and a prospectus describing the new security
– Securities and Exchange Commission (SEC)
• The agency that enforces federal securities regulations
– National Association of Securities Dealers (NASD)
• The organization responsible for the self-regulation of the
over-the-counter securities market
– Several other acts including Sarbanes-Oxley Act
(2002)
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Traditional Investment Alternatives
• Portfolio management
– Depends on your investment goals,
tolerance for risk, financial resources
available for investment
• Asset allocation, the time factor, and your
age
– Asset allocation—the process of spreading
your money among several different types
of investments to lessen risk
– The time factor—investing for the long term
or the short term
– Age—growth-oriented investments versus
conservative investments
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Investment Alternatives
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Traditional Investment Alternatives (cont’d)
• Bank accounts
– Advantages—bank accounts are safe (low risk) and
have definite rates of return
– Disadvantage—low risk means low investment returns
• Corporate bonds
– Primarily a long-term, income-producing investment
with a value that fluctuates with market interest rates
and the financial condition of the issuer
• Convertible bonds
– Interest-bearing corporate bonds that can also be
exchanged for a specific number of shares of common
stock
– Bond market value is equal to the underlying value of
the stock
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Bond Ratings
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Traditional Investment Alternatives (cont’d)
• Government bonds
– Considered risk free; pay low interest
– Treasury bills—sold in minimum units of $1,000; short
maturities
– Treasury notes—issued in $1,000 units with maturity of
1 to 10 years
– Treasury bonds—issued in minimum units of $1,000
with maturities from 10 to 30 years
– Savings bonds—(EE bonds) purchased for ½ their
maturity value
– Municipal bonds—issued by a state or local
government; may be exempt from federal taxes
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Traditional Investment Alternatives (cont’d)
• Common stock
– Dividend income
• Stock dividend—a dividend in the form of
additional stock
• Dividend payments—cash payments as the result
of a distribution of the company’s profits
– Increase in dollar value
• Capital gain— the difference between a security’s
purchase price and its selling price
• Market value—the price of one share of a stock at
a particular time
– Stock splits
• A division of each outstanding share of a
corporation’s stock into a greater number of
shares
• Reduces the stock price to a price range that
management feels is attractive for the stock
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Sample Common Stock Transaction
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Traditional Investment Alternatives (cont’d)
• Preferred stock
– Stock in a corporation that has a
claim on the dividends that
supercedes common stock
– Cumulative preferred stock
• Stockholders have priority claim to full
payment of all omitted dividends and
corporate assets
– Convertible preferred stock
• Stock that pays dividends and can
also be exchanged for a fixed number
of shares of common stock
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Traditional Investment Alternatives (cont’d)
• Mutual funds
– A professionally managed investment vehicle that combines and
invests the funds of many individual investors
– Closed-end funds
• Funds with a fixed number of shares
– Open-end funds
• Funds with an unlimited number of shares
– Net asset value (NAV)
Net asset value = Value of the fund’s portfolio – Liabilities
Number of shares outstanding
• Current market value of a mutual fund’s portfolio
minus the mutual fund’s liabilities and divided by
the number of outstanding shares
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Traditional Investment Alternatives (cont’d)
• Mutual funds (cont’d)
– Load funds
• Investors pay sales and purchase fees
every time they purchase shares
– No-load funds
• No sales or purchase fees are charged
– Yearly management fee
– Managed funds
• Professional fund manager chooses
securities in the fund
– Index funds
• Managers buy stocks or bonds contained in
an index (such as Standard & Poor’s 500)
– Family of funds
• A group of mutual funds managed by one
investment company
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Traditional Investment Alternatives (cont’d)
• Types of mutual fund investments
–
–
–
–
–
–
–
–
–
Aggressive growth stock funds
Global stock funds
Growth stock funds
High-yield (junk) bond funds
Income stock funds
Index funds
Long-term U.S. bond funds
Sector stock funds
Small-cap stock funds
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Traditional Investment Alternatives (cont’d)
• Real estate
– Advantage
• One of the best hedges against
inflation
– Disadvantages
• Risk of the property losing of
value due to poor location
• Buyers may be difficult to locate
• Real estate market may be in
decline at time of sale
• Taxes, mortgage interest, and
Installment payments can be a
heavy burden
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Real Estate Checklist
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High-Risk Investment Techniques
• Selling short
– The process of selling stock that an investor does not
actually own but has borrowed from a brokerage firm
and will repay at a later date
– Assuming that the stock is overvalued and will soon
decrease in price, the investor intends to repay the
brokerage later with less
costly stock, resulting in a profit for the investor
• Buying stock on margin
– Buying stock by borrowing part of the purchase price,
usually from a stock brokerage firm
• Margin requirement—the portion of the price of a stock
that cannot be borrowed; set by the Federal Reserve
Board
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High-Risk Investment Techniques (cont’d)
• Other high-risk
investments
–
–
–
–
–
–
Stock options
Commodities
Precious metals
Gemstones
Coins
Antiques and
collectibles
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Sources of Financial Information
• The Internet
–
–
–
–
–
–
–
www.bloomberg.com
http://money.cnn.com
www.financecenter.com
www.fool.com
www.quicken.com
www.sec.gov
http://finance.yahoo.com
• Newspaper coverage of securities transactions
– Common and preferred stocks
– Bonds
– Mutual funds
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Reading Stock Quotations
Source: Wall Street Journal, January 14, 2006, p. B5
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Reading Bond Quotations
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Reading Mutual Fund Quotations
Source: Wall Street Journal, January 14, 2006, p. B12.
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Sources of Financial Information
• Other sources of financial information
– Investors’ services
• Moody’s, Standard & Poor’s, Mergent, Value Line,
Morningstar, Lipper Analytical Services, Wiesenberger
Investment Companies
– Brokerage firm analysts’ reports
• UBS PaineWebber, Smith Barney, Merrill Lynch
– Business periodicals
•
•
•
•
Business Week, Fortune, Forbes
Advertising Age, Business Insurance
U.S. News & World Report, Time, Newsweek
Money, Kiplinger’s Personal Finance Magazine,
Consumer Reports
– Corporate reports
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Sources of Financial Information (cont’d)
• Security averages
– An average of the current market prices of
selected securities
– Dow Jones Industrial Average
• 30 leading industrial corporations
–
–
–
–
Standard & Poor’s 500 Stock Index
New York Stock Exchange Composite Index
American Stock Exchange Index
Nasdaq Composite Index
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