Section 8 (Investing)

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Personal & Family Finance

Section 8

Investing

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Why would you want to invest your money?

What are some ways you can invest your money?

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Goals and Investment Alternatives

Reasons for investing: Enjoyment such as your home or antiques Current income such as interest or dividends Providing for future needs such as retirement To reduce your current tax liability

Types of investments Tangible assets: Assets you can touch such as a house Intangible investments: Assets such as stocks and bonds

that are paper assets

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Tangible Investments

Advantages: Can enjoy or use May provide a good

hedge against inflation

May have greater control over return

May offer significant tax advantages

Disadvantages: Can involve work and

inconveniences Not liquid so not

easily bought and sold

Usually have high carrying costs, such as insurance or taxes

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Factors to Consider Before Investing

Do you want current or future return? Investing versus speculating

What is your income tax situation? What is your attitude towards risk?

Risk averse investors have a low tolerance for risk. Risk seeking investors have a high tolerance for risk. Investors need to understand their risk profile before

investing. If an investor wants a higher rate of return, they must

accept higher risk to earn a higher rate of return.

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Basic Investment Alternatives

Investments Held for Liquidity Securities with Long or No Maturities Pooling Arrangements Contractual Claims Tangible Assets

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Investments Held for Liquidity

Bank accounts Savings Certificates of deposit Money market deposit accounts

Money market mutual funds Series EE and Series HH bonds

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Securities with Long or No Maturities

Bonds and notes issued by: The U.S. Treasury and other federal agencies State and local governments Corporations

Preferred stock issued by corporations Common stock issued by corporations Bonds and notes mature from one to thirty years Stock never matures because it is ownership in a

business

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Pooling Arrangements

Mutual funds Income funds Growth funds Balance funds Index funds

Investment trusts Limited partnerships

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Contractual Claims

These are very high risk investments because their value is dependent upon the value of other assets

Some of these assets are: Warrants and rights Call and put options Commodity futures Financial futures

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Tangible Assets

Real estate Personal residence Rental properties

Gold and other metals/minerals Jewelry and collectibles

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Organized Exchanges

A physical place where buyers and sellers meet to trade securities. Examples are the New York and American Stock Exchanges

New York Stock Exchange (NYSE): It is the largest exchange in the world. It is known as the “Big Board”.

American Stock Exchange (AMEX): It is much smaller than the NYSE. It is now affiliated with NASDAQ.

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How the NYSE Works Securities are traded at designated sites on the floor,

which are called “posts”. You must have a “seat” to trade on the floor. Seat owners are commission brokers, floor brokers,

floor traders, and specialists. Specialists play a key role in maintaining an orderly

market. A specialist stands ready to take the opposite side of a

trade. If an investor wants to buy a stock and there is not another investor who wants to sell, the specialist will sell.

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The Over-the-Counter Market

Largest exchange, in terms of number of issues traded Securities are traded through a communication system

called National Association of Securities Dealers Automated Quotations System (NASDAQ).

Mostly small companies and high-tech companies are traded in this market. High-tech companies: Intel, Microsoft, etc.

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How SIPC Insurance Works

Suppose you own 100 shares of GM when your broker closes down. GM’s price on that day is $50 a share. Your account is worth $5,000 that day.

Two weeks later, your account is taken over by a new broker who confirms your ownership of 100 shares. GM’s price has fallen to $30 a share.

SIPC only guarantees delivery of the shares; but, you lose $2,000. GM’s share price decline is unrelated to the failure of your

broker.

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The Sarbanes-Oxley Act of 2002

This law was passed in response to some of the financial scandals of 1990 such as the failure of Enron, WorldCom, etc.

The act institutes reforms to improve corporate responsibility and financial disclosures. Stock analysts are also required to disclose potential

conflicts of interest that might influence their stock ratings. It also was created to combat corporate and

accounting fraud. It created the Public Company Accounting Oversight

Board (PCAOB).

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Other Regulation

States have what are called “Blue Sky” laws. These are similar to federal laws. The laws apply to intrastate Security Sales.

Self-regulation is also provided by the National Association of Securities Dealers (NASD) through: Dealers Rules of Fair Practice Code of Procedure Uniform Practice Code

Binding arbitration is an important component of self-regulation.

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Using the Services of a Stockbroker

Most financial investments are bought and sold with the help of a securities dealer (stockbroker).

Stockbrokers are distinguished in terms of the level of service provided as well as the fees.

Investors can choose among the following: Full-service firms Discount brokers Internet trading

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Selecting a Stockbroker

Full-service firms feature: Research that identifies investment opportunities Representatives to help with portfolio planning Access to new stock offerings Dedicated advisor who works directly with customer High commissions

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Selecting a Stockbroker (Con’t)

Discount brokers feature: Possibly no personal contact; you trade over an 800

number or over the Internet Therefore, discount brokers are most appropriate for

customers who have some trading experience and are comfortable placing orders

Lower commissions-savings can be as high as 90% versus a full-service firm

Internet trading: both full-service and discount brokers offer this service due to its low cost.

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Kinds of Accounts Cash account is similar to a charge account except

the purchase must be paid for within three working days. The broker will hold the securities or you can ask to have

them sent to you. Margin accounts allow you to borrow money to

purchase securities. Currently, you can borrow 50% of the cost of securities. You are only required to deposit 50% of the amount. Since you are borrowing money, you are charged interest. Borrowing money increases your risk!

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How Margin Works

You must deposit funds equal to 50% of the value of the securities purchased. This is your initial margin requirement.

There is also a maintenance margin requirement (MMR) of 25%. Your equity in the account cannot be less than 25%. If the stock prices fall, you may get a margin call from the

broker. You will be required to deposit additional funds.

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Margin Example

You buy 100 shares of GM stock @ $50 per share Total purchase = $5,000 You must deposit $2,500 to meet your initial margin. You borrow the balance ($2,500) from the broker’s firm.

You will get a margin call if the total value of the securities falls below $3,333. Solve this equation: Minimum value of securities = broker’s loan/(1 – MMR)

= $2,500/(1 – 0.25) = $3,333 With 100 shares, GM would have to fall to $33.33 per

share for you to get a margin call. You would have lost $1,667 ($5,000 – $3,333)

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Finding Investment Information

Company sources The Annual and Quarterly Reports; also company Web site

Investment advisory services Examples: Value Line, Moody’s, Standard and Poor’s

Newspapers and magazines Examples: Wall Street Journal, Investor’s Business Daily,

Barron’s Computer data sources

Internet as well as companies such as Bloomberg

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What Is a Bond?

A bond is simply a loan. It is a marketable IOU. Bond parties

The issuer who is borrowing money The investor who lends the money

The loan Specifies interest payments Has a maturity, such as 20 years

The bond certificate Is a small part of the overall loan Is easily traded in the bond market

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Bond Certificate

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Your Rights as a Bondholder

Bondholders are creditors. They have rights comparable to the rights of other creditors.

A bond indenture is the contract between the issuer and the bondholders that spells out the rights of the bondholders. It is similar to a loan agreement that you sign when you

borrow money. Protective covenants are restrictions on the issuer.

These are included in the indenture and they are intended to strengthen the bondholders’ position.

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Zero Coupon Bonds

Zero coupon bonds do not pay interest during the life of the bond.

Interest is earned by paying less than the face value of $1,000 to buy the bond. Example: you pay $500 today to buy a bond that will be

redeemed in eights years for $1,000 A savings bond is an example of a zero coupon bond.

You buy it for $50 and it is redeemed for $100 in the future.

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Convertible Bonds

These bonds can be converted into common stock. The conversion rate is the number of shares of stock

acquired by converting 1 bond; e.g., 40 shares per bond. Conversion value of the bond

This is the bond value if it was converted into common stock.

It is determined by multiplying the stock price by the conversion rate.

For example: Stock price = $30; the conversion rate is 40 shares per bond; conversion value = $30 × 40 = $1,200

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Investing in Corporate Bonds

Trading costs can be high Commission cost The bid-ask spread

Callable bonds are bonds that can be called prior to maturity. No interest is paid after the call date

Mutual funds may be the best way for individual investors to invest in bonds.

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Government-Issued Bonds

U.S. Treasury Securities U.S. Agency Bonds

Conventional Mortgage-backed

Municipal Bonds General obligation (GO) bonds Revenue bonds

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U.S. Treasury Bonds

The characteristics are the same as corporate bonds: Face value of $1,000 A maturity date such as 10 years Semiannual coupon payments

Investors can buy these directly from the Federal Reserve Bank

Free of default risk May be subject to price risk but the degree depends

on the time to maturity

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U.S. Agency Bonds

Conventional bonds have the same characteristics as U.S. Treasury Bonds

Mortgage-Backed Bonds: Issued by agencies such as Fannie Mae Agency buys mortgages from local lenders Creates a pool of similar mortgages and issued bonds

backed by these pools of mortgages Mortgage payments are “passed through” to the bond

buyers Due to the complexities of these bonds, it is best to

invest through a mutual fund.

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Municipal Bonds (Munis)

Issued by cities, counties, or states to fund projects General obligation (GO) bonds

These are backed by the full taxing authority of the issuer. Revenue bonds

Backed only by the revenues of the project that the bonds are financing

These bonds are considered more risky since they are dependent upon the revenues from a project.

Most municipal bonds are free of federal income tax and may be free of state income tax.

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Mutual Funds A mutual fund is an investment company that pools

the funds of many individuals to invest in stocks, bonds, and other investment securities.

Investors buy shares in the mutual fund. The mutual fund buys: Shares in companies and/or,

bonds of companies, municipalities, governments and/or, other investment securities

A fund’s net asset value (NAV) is the total value of all the assets the fund owns (minus any liabilities) divided by the number of shares issued by the fund.

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Selecting a Mutual Fund

Evaluate performance. Review the fund’s current portfolio. Examine expenses and turnover. Review evaluations in popular magazines and

newspapers. Consult a professional evaluation service such as

Morningstar or Lipper Analytical Services.

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Other Evaluation Items

Review the fund’s current portfolio Is there adequate diversification?

Review the fund’s operating expenses Usually expressed as a percent of net assets Low expense ratios are desirable Compare to other funds with similar investment objectives

Examine the portfolio turnover percent Turnover percent measures the trading frequency High numbers = high trading

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Portfolio Diversification

Reduces risk Minimizes return

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Investment Selection

Aggressive investor: 100% stocks: 1/3 large company, 1/3 small company, 1/3

international Cautious investor:

30% large company growth stocks, the balance in bonds, including zero coupon

Investor who needs current income: 50% high-quality corporate bonds, 25% medium-quality

corporate bonds, and 25% income stocks