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The Investment Process
The Investment Process
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 2-1
The Investment Process
“Don’t Gamble! Take all your savings and buy some good
stock and hold it till it goes up. If it don’t go up, don’t buy it.”
– Will Rogers
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Learning Objectives
2-3
Investing Overview
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Investor Constraints
• Liquidity. How high is the possibility that you need to sell the asset
quickly?
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Asset Allocation or Security Selection?
• After setting up your IRA (highly advised), you might decide to invest other
money.
• If so, you need to choose the type of brokerage account and your
broker/advisor from:
― full-service brokers
― discount brokers
― deep-discount brokers
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Securities Investor Protection Corporation
• Most brokerage firms belong to the SIPC, which insures each account for up to
$500,000 in cash and securities, with a $250,000 cash maximum.
• Important: The SIPC does not guarantee the value of any security (unlike
FDIC coverage).
• Rather, SIPC protects whatever amount of cash and securities that were in
your account, in the event of fraud or other failure.
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Advisor-Customer Relations
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A Cash Account
(a)Open
(a) Openthe
theaccount
account
(b)Deposit
(b) Deposit$10,000
$10,000
(c)Buy
(c) Buy100
100Shares
Shares
ofNordstrom
of Nordstrom(JWN)
(JWN)
at$63
at $63per
pershare
share
(d)Pay
(d) PayCommission,
Commission,
Say$50
Say $50
(e)Cash
(e) CashAccount
Accounthas:
has:
$3,650ininCash
$3,650 Cash
$6,300ininStock
$6,300 Stock
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Margin Accounts
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Example: Margin Accounts,
The Balance Sheet
• You buy 1,000 Pfizer (PFE) shares at $80 per share.
Liabilities and
Assets Account Equity
1,000 Shares, PFE $ 24,000 Margin Loan $ 6,000
Account Equity $ 18,000
Total $ 24,000 Total $ 24,000
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Margin Accounts
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Example: The Workings of
a Margin Account, I.
• Your margin account requires:
• an initial margin of 50%, and
• a maintenance margin of 30%
• You have $20,000, and you want to buy as much WHOA as you can.
Liabilities and
Assets Account Equity
800 Shares of WHOA @ $ 40,000 Margin Loan $ 20,000
$50/share
Account Equity $ 20,000
Total $ 40,000 Total $ 40,000
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Example: The Workings of
a Margin Account, II.
Liabilities and
Assets Account Equity
800 Shares of WHOA @ $ 28,000 Margin Loan $ 20,000
$35/share
Account Equity $ 8,000
Total $ 28,000 Total $ 28,000
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Example: The Effects of Margin, I.
• You have $30,000 in a margin account; 60% initial margin
required.
• You can buy $50,000 of stock with this account (why?).
• Your borrowing rate from your broker is 6.00%.
• Suppose you buy 1,000 shares of Coca-Cola (KO), for $50/share.
• Assume no dividends, and that your borrowing rate is still 6.00%,
what is your return if:
― In one year, KO stock is selling for $60 per share, but you did not borrow
money from your broker?
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Example: The Effects of Margin, II.
• If you pay off the loan with interest, your account balance is: $60,000 –
$21,200 = $38,800.
• Suppose Coca-Cola stock was selling for $40 per share instead of $60 per
share? What is your return?
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Example: The Effects of Margin, III.
• Coca-Cola stock is selling for $60 per share, but you did not borrow from
your broker.
• You started with $30,000, which means you were able to buy $30,000 / $50 =
600 shares.
• Suppose Coca-Cola is selling for $40 per share instead of $60 per share.
What is your return in this case?
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Example: How Low Can it Go?
• Suppose you want to buy 300 shares of Pepsico, Inc. (PEP) at $55
per share.
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Example: How Low Can it Go? (Answer)
• The margin call occurs when the price of Pepsico, Inc. hits $36.67. How so?
Number of Shares P *
Amount Borrowed
P
* Number of Shares
1 - Maintenance Margin Level
So here,
$6,600
P* 300 22 $36.67.
1 - 0.40 0.60
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Example: Annualizing Returns
on a Margin Purchase, I.
• You sell your Wal-Mart shares 4 months later for $63 per share.
• There were no dividends paid (and suppose the prices above are net of
commissions).
Answer: First, you have to repay the 3-month loan, so t = (3/12 = .25)
(1 0.0736) 4
1.3285
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Hypothecation and Street Name Registration
―Advisory account - You pay someone else to make buy and sell decisions
on your behalf.
―Wrap account - All the expenses associated with your account are
“wrapped” into a single fee.
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Retirement Accounts:
Company Sponsored Plans, I.
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Retirement Accounts:
Company Sponsored Plans, II.
• The general investing approach applies to your retirement plan.
― You decide your percentage allocations to asset classes (like stocks, bonds, and T-bills) and
then choose particular securities (i.e., mutual funds) in each asset class.
― You will also make the decision whether to invest in U.S. securities, securities in other
regions of the world, securities in specific countries, large company securities, small
company securities, or a combination of these categories.
• Of course, nothing is free. You must pay taxes on the withdrawals you make
during retirement.
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Individual Retirement Accounts, IRAs
Borrow
Borrow Sellthe
Sell the Buy
Buy Return
Return
shares
shares Shares
Shares shares
shares the
the
from
from ininthe
the Fromthe
From the
shares
shares
someone
someone market
market market
market
2-34
Short Sales, II.
• Your broker has a 50% initial margin and a 40% maintenance margin on short
sales.
Liabilities and
Assets Account Equity
• Sold at $30, value today is $20, so you are "ahead" by $10 per share, or
$1,000.
Liabilities and
Assets Account Equity
• You sold short at $30, stock price is now $40, you are "behind" by $10 per
share, or $1,000. (“He who sells what isn’t his’n, must buy it back—or go to
prison.”)
• Also: new margin = $500 / $4,000 = 12.5% < 40% Therefore, you are subject
to a margin call.
• Note that with a short position, you may lose more than your total
investment, as there is no theoretical limit to how high the stock price
may rise.
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Finding Actual Short Positions
(from finance.yahoo.com)
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Forming a Real Investment Portfolio, I.
• Take the Risk Tolerance Quiz in the textbook.
• What score did you get?
• How does your score compare to these people?
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Forming a Real Investment Portfolio, II.
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AAII Asset Allocation Models
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Useful Internet Sites
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Chapter Review, I.
• The importance of an investment policy statement (IPS)
―The investment policy statement (IPS) identifies the objectives (risk and
return) of an investor, as well as the constraints the investor faces in
achieving these objectives.
―The IPS provides an investing “roadmap” and will influence the
strategies, type of account, and holdings an investor chooses.
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Chapter Review, II.
• Brokerage Accounts
― Cash Accounts
― Margin Accounts and how to calculate initial and maintenance margin
― A Note on Annualizing Returns
• Short Sales
― Basics of a Short Sale
― Some Details
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