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F u n d a m e n t a l s o fI N V E S T I N GELEVENTH EDITION

L A W R E N C E J . G I T M A N , C F PS a n D i e g o S t a t e U n i v e r s i t y

M I C H A E L D . J O E H N K , C F AA r i z o n a S t a t e U n i v e r s i t y

S C O T T B . S M A R Ti n d i a n a U n i v e r s i t y

Boston Colu mbu s Indiana polis New York San Francisco Upper Saddle RiverAmsterdam Cape Town Dubai L ondon Madrid Milan Mu nich Par is Montreal Toronto

Delhi Me xico City Sao Paulo Sydney Hon g Kong Seoul Singapore Taipei Tokyo

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C o n t e n t s

Part O n e Preparing t o Invest 1CHAPTER 1 T h e In v es tm en t E n v ir on m en t 2

E T H I C S IN I N V E S T I N GThe Price for Behaving BadlyPAGE 17

MARKETS IN CR SISYour Money Back, GuaranteedPAGE 19

O p e n i n g V ig n e t t e 2I n v e st m e n t s a n d t h e I n v e st m e n t P r o ce s s 3

Types of Investm ents 3 / Th e Structure of the Investm ent Process 5I n v e s t m e n t V e h icl e s 7

Shor t -Term Investments 8 / Com mo n Stock 8 / Fixed-IncomeSecuri ties 9 / Mu tual Fund s 10 / Hedge Fund s 10Derivative Securities 10 / O the r Pop ular Investm ents 11

M a k in g I n v e s t m e n t P l a n s 1 1Steps in Investing 11 / Con sidering Person al Taxes 13Investing Over the Life Cycle 16 / Investments and theBusiness Cycle 16

M e e t i n g L iq u i d it y N e e d s : I n v e s t in g i n S h o r t-T e r m V e h ic le s 1 8The Role of Short-Term Investments i 8 / Popular Short-TermInvestme nts 19 / Investm ent Suitabili ty 19

C a r e e rs in F i n a n c e 2 2S u m m a ry 2 5 / D is c u s s i o n Q u e s t io n s 11 I P ro b l e m s 28 /C a s e P r o b le m s 2 9 / E x ce l w i t h S p r e a d s h e e t s 3 1

CHAPTER 2

MARKETS IN CR S SSEC Bans Short SellingPAGE 58

Securities M arkets and Transactions 32O p e n i n g V ig n e t t e 3 2Se c ur it ie s Ma r k ets 3 3

Types of Securit ies M ark ets 33 / Brok er M ark ets and DealerM arkets 38 / A l ternat ive Trading Systems 4 3 / G eneral M arketCo nditio ns: Bull or Bear 43

viii

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CO NTENTS I X

G l o b a l i za t i o n o f S e c u r it ie s M a r k e t s 4 4Grow ing Importance of International Ma rkets 44 / InternationalInvestm ent Performance 45 / W ays to Invest in ForeignSecurities 46 / R isks of Investing Interna tionally 46

T r a d in g H o u r s a n d R e g u l a t i o n o f S e c u r it ie s M a r ke t s 4 8Trading Hours of Securities Markets 48 / Regulation ofSecurities Markets 48

B a s i c T y pe s o f S e c u r it ie s T r a n s a c t io n s 5 0Long Purchase 50 / Marg in Trading 51 /Short Selling 56

S u m m a r y 6 0 / Dis c u s s i o n Q u e s t io n s 6 2 / P r o b le m s 6 3 /C a s e P r o b le m s 6 5 / E x ce l w i t h S p r e a d s h e e t s 6 7

CHAPTER 3E T H I C S IN I N V E S T I N GDid Martha Stewart Cross theLine? PAG E 97

MARKETS I N CRISISTech Stocks and Online TradingGo Bust PAG E 101

Investm ent Information and SecuritiesTransactions 68O p e n i n g V ig n e t t e 6 8O n l i n e I n v e s t in g 69

Getting Started in Online Investing 69 I Pros and Cons of Usingthe Internet as an Investment Tool 74T yp e s a n d S o u r ce s o f I n ve s t m e n t I n f o r m a t io n 7 5

/ Types of Inform ation 77 / Sources of Inform ation 77U n d e r s t a n d i n g M a r ke t Av e ra g e s a n d I n d e x e s 8 8

Stock M ark et Averages and Indexes 88 / Bond Ma rke tIndicators 93M a k in g S e c u r it ie s T r a n s a c t io n s 9 4

The Role of Stockbro kers 94 / Basic Types of Ord ers 99Online Transa ctions 100 / Tran saction Costs 102 / InvestorProtec tion: SIPC and Arb itration 103

I n v e s t m e n t Ad v is e rs a n d I n v e s tm e n t C l u b s 1 0 5Using an Investmen t Adviser 105 / In vestmen t Clubs 106S u m m a ry 1 0 7 / D is c u s s i o n Q u e s t io n s 1 1 0 / P r o b l e m s 1 1 1 /

C a s e P r o b le m s 1 1 3 / E x ce l w i t h S p r e a d s h e e t s 1 1 5

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CONTENTS

P a rt T w o I m po rt a n t C o n ce pt u a l T o o l s 117CHAPTER 4

MARKETS IN CRISISRecession Pushes Prices D own

! PAGE 122

.MARKETS I N CRISISDisappearing DividendsPAGE 134

APPENDIX 4A

Return an d Risk 118O p e n i n g V ig n e t t e 1 1 8T h e C o n c e p t o f R e t u r n 1 1 9

Com ponen ts of Return 119 / W hy Return Is Imp ortant 120Level of Retu rn 121 / Historica l Re turns 122 / Time Valueof Mo ney and Returns 123

M e a s u r i n g R e t u r n 1 2 5Real, Risk-Free, and Required Retu rns 125 / H oldin g PeriodRetu rn 126 / Yield: The Internal Ra te of Re turn 128 / F indingGrow th Rates 132

R is k : T h e O t h e r S i d e o f t he C o i n 1 3 3Sources of Risk 133 / R isk of a Single Asset 136 / AssessingRisk 139 / Steps in the Decision Process: Com bining R eturnand Risk 141

S u m m a ry 1 4 2 / D is c u s s i o n Q u e s t io n s 1 4 3 / P r o b le m s 1 4 4 / C a s eP r o b l e m s 1 4 7 / E x ce l w i t h S p r e a d s h e e t s 1 4 9 / C h a p t e r- Op e n i n gP r o b le m 1 5 0T he T im e V a lu e o f M o n e y 151O p e n i n g V ig n e t t e 1 5 1I n t e r e s t : T h e B a s i c R e t u r n t o S a v e rs 1 5 1

Simple Interest 1 51 / Com po und Interest 151C o m p u t a t io n a l A id s f o r U s e in T i m e V a l u e C a l cu l a t io n s 1 53

Financial Calcu lators 153 / Com puters and Spreadsheets 154F u t u re V a l u e : A n E x te n s i o n o f C o m p o u n d in g 1 54F u t u re V a l u e o f a n A n n u i t y 1 5 5P r e s e n t V a l u e : A n E x t e n s i o n o f F u t u r e V a l u e 1 5 6T h e P re s e n t V a l u e o f a S t re a m o f Re t u r n s 1 5 7Present Value of a M ixed Strea m 158 / P resent Value of anAnnuity 159S u m m a r y 1 6 0 / P r o b l e m s 1 6 0

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CO NTENTS x

CHAPTER 5MARKETS I N CR SIS

Bulging BetasPAGE 178

M odern Portfolio Concepts 164O p e n i n g V ig n e t t e 1 6 4P r i n cip le s o f P o r t f o l io P l a n n i n g 1 6 5

Portfolio Objectives 165 / Portfolio Return and StandardDev iation 165 / C orrelatio n and Diversification 167 IIntern ation al Diversification 172

T h e C a p it a l A s s e t P ricin g M o d e l (C A P M ) 1 7 5Com ponen ts of Risk 175 / Beta: A Popu lar Mea sure ofRisk 175 / The CAP M: Using Beta to Estimate Return 178

T ra d i tio n a l V e r su s M o d e r n P o r t fo l io M a n a g e m e n t 1 81The Tradit ional App roach 181 / M odern PortfolioTheory 182 / Reconciling the Tradit ional Approa chand MP T 187

S u m m a r y 1 88 / D i s cu s s i o n Q u e s t io n s 1 9 0 / P r o b le m s 1 9 1 / C a s eP r o b l e m s 1 9 6 / E x ce l w i t h S p r e a d s h e e t s 1 9 9 / C h a p t e r -O p e n i n gP r o bl e m 2 0 0C F A E x a m Q u e s t io n s 2 0 2

P a rt T hre e I n ve s t in g in C o m m o n S t o cks 205CHAPTER 6 C o m m o n Stocks 206

The Lumbering B ear[ PAGE 207O p e n i n g V ig n e t t e 2 0 6W h a t S t o c ks H a v e t o O ff e r 2 0 7

The Appeal of Common Stocks 207 / Putt ing Stock PriceBehavior in Perspective 207 / From Stock Prices to StockRetu rns 208 / A Real Estate Bubble Goes Bust and So Doesthe M arke t 209 / The Pros and Cons of Stock Ownership 209B a s ic C h a ra c te r is t ic s o f C o m m o n S t o c k 2 1 2

Common Stock as a Corporate Securi ty 212 I Buying andSelling Stocks 2 15 / C om mo n Stock Values 21 7C o m m o n S t o ck D iv id e n d s 2 1 8

The Dividend Decision 21 9 / Types of Dividends 22 1 / DividendReinvestment Plans 222T y pe s a n d Us e s o f C o m m o n S t o ck 2 2 3

Types of Stocks 22 3 / Investing in Foreign Stocks 229 /Alternative Investment Strategies 233S u m m a ry 2 3 6 / D is c u s s i o n Q u e s t io n s 2 3 8 / P r o bl e m s 2 4 0 / C a s eP r o b l e m s 2 4 2 / E x ce l w i t h S p r e a d s h e e t s 2 4 4 / C h a p t e r -O p e n i n gP r o b le m 2 4 5

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x i i CO NTENTS

CHAPTER 7Lahde Earns 1000% and RetiresPAGE 249

Cooking the Books: What WereThey Thinking? PAGE 263

MARKETS I N CRISISCredit Constraints BindPAGE 267

Analyzing Com m on Stocks 246O p e n i n g V ig n e t t e 2 4 6Securit y An a lys is 247

Principles of Security Analysis 247 / Who Needs Security Analysisin an Efficient Ma rke t? 24 8E c o n o m i c A n a l y s is 2 4 9

Economic Analysis and the Business Cycle 250 / Key EconomicFactors 25 0 / Developing an Econom ic Ou tlook 25 1I n d u s t r y A n a l y s is 2 5 4

Key Issues 25 4 / D eveloping an Industry Outl ook 25 6F u n d a m e n t a l A n a l ys is 2 5 8

The Con cept 2 58 / Financial Statements 259 / FinancialRat ios 26 2 / Interpret ing the Nu mb ers 272

S u m m a ry 2 7 2 / D is c u s s i o n Q u e s t io n s 2 7 8 / P r o b le m s 2 7 8 /C a s e P r o b l e m s 2 8 6 / E x ce l w i t h S p r e a d s h e e t s 2 8 4 / C h a pt e r-O p e n i n g P r o b le m 2 8 5

CHAPTER 8 Stoc k V a lu a ti o n 286MARKETS I N CRISIS

P/E Ratios Can Be Mislea dingPAGE 230

Stock Analysts: Don't Alw aysBelieve the Hype PAGE 299

O p e n i n g V ig n e t t e 2 8 6V a l u a t i o n : O b ta i n in g a S t a n d a rd o f P e r f o rm a n c e 2 8 7

Valuing a Company and Its Future 287 / Developing an Estimateof Futu re Behavior 29 3 / The Valuation Process 29 5S t o c k V a l u a t i o n M o d e l s 2 9 8

The Dividend Valuat ion Model 298 / Other Approaches to StockValuations 306 / O ther Price-Relative Procedures 310

S u m m a ry 3 1 3 / D i s cu s s i o n Q u e s t io n s 3 1 4 / P r o b l e m s 3 1 5 / C a s eP r o b l e m s 3 1 9 / E x ce l w i t h S p r e a d s h e e t s 3 2 1 / C h a p t e r- Op e n i n gP r o b le m 3 2 2

CHAPTER 9

I Loss Aversion and TradingVolume PAGE 331aH H -iling

M arket Efficiency, Behavioral Finance,and Technical Analysis 323O p e n i n g V ig n e t t e 3 2 3E ff icient Ma rket s 324

Levels of M ark et Efficiency 324 / M ark et Anom alies 326 /Possible Exp lanatio ns 328

B e h a v io r a l F i n a n c e : A C h a l l e n g e t o t h e E f f ic ie n t M a r k e t s H y po t h e s i s 3 2 9Investor Behavior and Security Prices 3 29 / Implication s ofBeh avioral Finance for Security Analysis 334

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CO NTENTS XII

T e c h n i c a l A n a l y s i s 335Using Technical Analysis 335 / Measur ing the M arke t 336 /The Big Picture 336 / Technical Cond it ions Within theM arke t 338 / Trading Rules and Measures 341 / Charting 344

S u m m a r y 350 / D is c u s s io n Q u e s t i o n s 351 / P r o b l e m s 352 / C a s eP r o b l e m s 354 / E x c e l w i t h S p r e a d s h e e t s 357C F A E x a m Q u e s t io n s 359

P a rt F o u r I n v e s t in g in F ixe d -I n co m e S e c u rit ie s 361CHAPTER 10 F ix e d - I n c o m e S e c u r it ie s 362

O p e n i n g V ig n e t t e 362W h y I n v e s t in B o n d s ? 363Yield Spreads ApproachRecords PAGE 365

MARKETS I N CR S I 'Im p lic it G ua r a nt e e B e c om e sExplicit PAGE 379

Putt ing Bond Market Performance in Perspective 363 / Exposureto Risk 367E s s e n t ia l F e a t u re s ofa B o n d 369

Bond Interest and Principal 369 / Matur i ty Date 369 / Principlesof Bond Price Behavior 370 / Pricing a Bond 371 / CallFeaturesLet the Buyer Beware! 372 / Sinking Funds 372 /Secured or Unsecured Debt 373 / Bond Ratings 373T h e M a r k e t for Debt Securi t ies 376Major Market Segments 377 / Specialty Issues 382 / A GlobalView of the Bond Market 386C o n v e r t ib l e S e c u r it ie s 388

Convertibles as Investment Outlets 388 / Sources ofValue 391 / Measur ing the Value of a Convert ible 392S u m m a r y 395 / D i s c u s s i o n Q u e s t i o n s 397 / P r o b l e m s 398 / C a s eP r o b l e m s 400 / E x c e l w i t h S p r e a d s h e e t s 402 / C h a p t e r - O p e n i n gP r o b l e m 403

CHAPTER 11 Bond Valuation 404O p e n i n g V i g n e t t e 404T h e B e h a v io r of M a r k e t I n t e r e s t R a t e s 405

Keeping Tabs on Market Interest Rates 405 / What CausesRates to Move? 407 / The Term Structure of Interest Ratesand Yield Curves 408

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XI V CONTENTS

The Pricing of Bonds 413The Basic Bond Valuation M odel 413 / AnnualCompounding 414 / Semiannual Compounding 415

Measures of Yield andReturn 416Current Yield 416 / Yield-to-Maturity 416 / Yield-to-Call 419Expected Return 420 / Valuing a Bond 422

Duration and Immunization 422The Concept of Duration 423 / Measuring Duration 424 / BondDuration andPrice Volatility 426 / Effective Duration 427 / Usesof Bond Duration Measures 428

Bond Investment Strategies 430Passive Strategies 430 / Trading on Forecasted Interest RateBehavior 430 / Bond Swaps 431

Summary 432 / Discussion Questions 434 / Problems 434 /Case Problems 437 / Excel with Spreadsheets 438CFA Exam Questions 440

Part Five Portfolio Management 443CHAPTER 12

MARKETS IN CRISISM u t u a l F un d V u l n e r a b i l i t yP A G E 44 6

ETHICS IN INVESTINGW h e n M u t u a l F u n d s B e h a v e dB a d l y P A G E 45 0

Mutual Fu nds: Professionally ManagedPortfolios 444Opening Vignette 444The Mutual Fund Concept 445

An Overview of Mutual Funds 445 / Open- or Closed-End Funds44 9 / Exchange-Traded Funds 451 / Some ImportantConsiderations 453 / Other Types of Investment Companies 458Types of Funds and Services 460

Types of Mutual Funds 461 / Investor Services 467Investing in Mutual Funds 470Investor Uses of Mutual Funds 470 / The Selection Process 471 /Investing in Closed-End Funds 475 / Measuring P erformance 477Summary 483 / Discussion Questions 484 / Problems 485 /Case Problems 488 / Excel with Spreadsheets 490 / Chapter-OpeningProblem 490

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CHAPTER 13MARKETS I N CRISIS

Baby Boomers DelayRetirement PAGE 497

The Virtues ofEthical Investing:The Remarkable Life ofJohnTempleton PAG E 509

M anaging Your O wn Portfolio 491O p e n i n g V ig n e t t e 491C o n s t r u c t i n g a P o r t f o l i o U s i n g an A s s e t A l l o c a t i o n S c h e m e 492

Investor Characteristics and Objectives 492 / Portfolio Objectivesand Policies 492 / Developing an Asset Allocation Scheme 493E v a l u a t i n g the P e r f o r m a n c e of I n d iv id u a l I n v e s t m e n t s 495

Obtaining Needed Data 496 / Indexes of InvestmentPerformance 496 / Measur ing the Performance ofInvestments 497 / Comparing Performance to InvestmentGoals 500A s s e s s i n g P o r t f o l i o P e r f o r m a n c e 501

Measuring Portfolio Return 502 / Compar ison of Return withOverall Market Measures 505 / Portfolio Revision 508T im in g T r a n s a c t io n s 509

Formula Plans 510 / Using Limit and Stop-Loss Orders 513 /Warehousing Liquidity 514 / Timing Investment Sales 514S u m m a r y 515 / D is c u s s io n Q u e s t i o n s 517 / P r o b l e m s 519C a s e P r o bl em s 523 / E x c e l w i t h S p r e a d s h e e t s 525C F A E x a m Q u e s t io n s 527

Part Six Derivative Securities 529CHAPTER 14

E T H I C S IN I N V E S T I N GExtraordinarily Good TimingPAGE 540

MARKETS I N CRISISThe Volatility IndexPAGE 542

Op tions: Puts and Calls 530O p e n i n g V ig n e t t e 530P u t and C a l l O p t i o n s 531

Basic Features of Puts and Calls 531 / OptionsM arke t s 534 / Stock Options 534Opt ions P ricing andT r a d i n g 537

The Profit Potential from Puts and Calls 538 / IntrinsicValue 539 / What Drives Options Prices? 541 / TradingStrategies 544S t o c k - I n d e x andOt her Types of O p t i o n s 552

Stock-Index Options: Contract Provisions 552 / InvestmentUses 554 / Other Types of Options 555S u m m a r y 558 / D is c u s s io n Q u e s t i o n s 559 / P r o b l e m s 560 /C a s e P r o bl em s 562 / E x c e l w i t h S p r e a d s h e e t s 564 / C h a p t e r - O p e n i n gP r o b l e m 565

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X V I CO NTENTS

CHAPTER 15E T H IC S IN IN V E S T I N GT r a d in g E n e r g y F u t u r e s a t E n r o nPAGE 57 7

MARKETS IN CRISISOil Isn't Recession ProofPAGE 578

Com modities and Financial Futu res 566Opening Vignette 566The Futures Ma rket 567

Ma rket Structure 567 / Trading in the Futures Market 569Commodities 572

Basic Characteristics 573 / Trading Commodities 576Financial Futures 579

The Financial Futures Market 579 I Trading Techniques 583 /Financial Futures and the Individual Investor 586 / Options onFutures 586Summary 588 / Discussion Questions 590 / Problems 59 1 /Case Problems 593 / Excel with Spreadsheets 595CFA Exam Questions 596Glossary G-lIndex 1-1Credits C-l

W E B CHAPTERS ( a t w w w . p e a r s o i i l l i i g l l i e r e d . c o m / g i t i n a a i i i )Ch apter 16 Investing in Preferred StocksCha pter 17 Tax-Advantaged InvestmentsChap ter 18 Real Estate and Othe r Tangible Investments