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Chapter 3The Investment Process
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The Investment ProcessThe 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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Don’t sell yourself short. Instead, learn about these key investment subjects: 1. The importance of an investment policy statement.
2. The various types of securities brokers and brokerage accounts.
3. How to calculate initial and maintenance margin.
4. The workings of short sales.
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Learning ObjectivesLearning Objectives
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Investing OverviewInvesting Overview
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Fundamental Question: Why invest at all?We invest today to have more tomorrow.Investment is simply deferred consumption.We choose to wait because we want more to
spend later.
Investors have their own investment objectives and strategies
The Investment Policy Statement (IPS) Designed to reflect your objectives and strategiesTwo parts
ObjectivesConstraints
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Objectives: Risk and ReturnObjectives: Risk and Return
In formulating investment objectives, the individual must balance return objectives with risk tolerance.Investors must think about risk and return.Investors must think about how much risk they
can handle.
Your risk tolerance is affected by Your ability to take risk Your willingness to take risk
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Investor ConstraintsInvestor Constraints
Resources. What is the minimum sum needed? What are the associated costs? Trading commissions? Subsequent transactions?
Horizon. When do you need the money? Buying a home? Retirement?
Liquidity. How high is the possibility that you need to sell the asset quickly? Are funds for emergency purposes or long term goals?
Taxes. Which tax bracket are you in? After tax returns are essential
Special circumstances. Does your company provide any incentive? What are your regulatory and legal restrictions?
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Investment Strategies and Investment Strategies and PoliciesPolicies Investment management. Should you manage your
investments yourself? Investment Advisor or Broker? Financial Planner?
Market timing. Should you try to buy and sell in anticipation of the future direction of the market?
Asset allocation. How should you distribute your investment funds across the different classes of assets? Dependent on your risk tolerance
Security selection. Within each class, which specific securities should you buy? Which stock and bonds to invest funds in & what percentage of funds to invest in each security?
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Asset Allocation or Security Asset Allocation or Security Selection?Selection?
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Is asset allocation or security selection more important to the success of a portfolio?
Most people are inclined to think security selection is the more important element for successful investing.
Research shows, however, that asset allocation is the more important determinant of portfolio returns. Many experts suggest: About 90 percent of portfolio performance stems from asset
allocation. So, 10 percent of portfolio performance comes from security
selection.
How is this result possible? Well, consider the Crash of 2008. Bonds outperformed stocks in 2008 Even those elusive “skilled stock pickers” might underperform
bonds Stocks tend to move together Even a “skilled stock picker” would have trouble beating bonds if most stock prices are performing
poorly relative to bond prices
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Choosing a Broker/AdvisorChoosing a Broker/Advisor
What do you do after carefully crafting your Investment Policy Statement (IPS)?
If so, you need to choose the type of brokerage account and your broker/advisor from:
1. full-service brokers2. discount brokers3. deep-discount brokers
These three groups can be distinguished by the level of service provided, as well as the level of commissions charged.
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Choosing a Broker/AdvisorChoosing a Broker/Advisor As the brokerage industry becomes more competitive, the differences
among broker types continues to blur.
Another important change is the rapid growth of online brokers, also known as e-brokers or cyberbrokers.
Online investing has really changed the brokerage industry. slashing brokerage commissions providing investment information Customers place buy and sell orders over the Internet
Many full-service brokers offer an advisory-based relationship for clients. Rather than charging commissions on every transaction, the
investment advisor charges an annual fee, say 1-2%, based on the account balance.
This fee covers all services associated with advice and trading. An advisory-based relationship can align the interests of the client
and the advisor.
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Advisor-Customer RelationsAdvisor-Customer Relations
There are several important things to remember when you deal with any broker/advisor:
Any advice you receive is not guaranteed.
Your broker works as your agent and has a legal duty to act in your best interest.
Brokerage firms, however, do make profits from brokerage commissions and/or annual fees.
Your account agreement will probably specify that any disputes will be settled by arbitration and that the arbitration is final and binding.
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Canadian Investor Protection FundCanadian Investor Protection Fund
Canadian Investor Protection Fund (CIPF): Insurance fund covering investors’ brokerage accounts when member firms go bankrupt or experience financial difficulties.
Most brokerage firms belong to the CIPF, which insures each account for up to $1,000,000 in cash and securities
Important: The CIPF does not guarantee the value of any security
Rather, CIPF protects whatever amount of cash and securities that were in your account, in the event of fraud or other failure.
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Opening Your Brokerage AccountOpening Your Brokerage Account
(c) Buy 100 Shares of Disney
at $33 per share
(c) Buy 100 Shares of Disney
at $33 per share
(e) $6,650 Cashin Account
$3,300 Stock In Account
(e) $6,650 Cashin Account
$3,300 Stock In Account
(d) Pay Commission,Say $50
(d) Pay Commission,Say $50
(b) Deposit $10,000into account
(b) Deposit $10,000into account
(a) Open a brokerageor trading account
(a) Open a brokerageor trading account
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Two Types of Brokerage AccountsTwo Types of Brokerage Accounts
A Cash account is a brokerage account in which securities are paid for in full.
A Margin account is a brokerage account in which, subject to limits, securities can be bought and sold short on credit.
(more on selling short later)
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Margin AccountsMargin Accounts
In a margin purchase, the portion of the value of an investment that is not borrowed is called the margin.
Of course, the portion that is borrowed incurs an interest charge.This interest is based on the broker’s call
money rate.
The call money rate is the rate brokers pay to borrow money to lend to customers in their margin accounts.
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Example: Margin Accounts, The Balance Example: Margin Accounts, The Balance SheetSheet
• You buy 1,000 Pfizer (PFE) shares at $24 per share.
• You put up $18,000 and borrow the rest.
• Amount borrowed = $24,000 – $18,000 = $6,000
• Margin = $18,000 / $24,000 = 75%
Assets
Liabilities and 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 AccountsMargin Accounts
In a margin purchase, the minimum margin that must be supplied is called the initial margin.
The maintenance margin is the margin amount that must be present at all times in a margin account.
When the margin drops below the maintenance margin, the broker can demand more funds. This is known as a margin call.
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Example: The Workings of a Margin Example: The Workings of a Margin AccountAccount• Your margin account requires: • an initial margin of 50%, and
• a maintenance margin of 30%
• A Share in Miller Moore Equine Enterprises (WHOA) is selling for $50. • You have $20,000, and you want to buy as much WHOA as you can.
• You may buy up to $20,000 / 0.5 = $40,000 worth of WHOA.
Assets
Liabilities and Account Equity
800 Shares of WHOA @ $50/share
$ 40,000 Margin Loan $ 20,000
Account Equity $ 20,000
Total $ 40,000 Total $ 40,000
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Example: The Workings of a Margin Example: The Workings of a Margin
AccountAccount • After your purchase, shares of WHOA fall to $35. (Woe!)
• New margin = $8,000 / $28,000 = 28.6% < 30%
• Therefore, you are subject to a margin call.
Assets
Liabilities and Account Equity
800 Shares of WHOA @ $35/share
$ 28,000 Margin Loan $ 20,000
Account Equity $ 8,000
Total $ 28,000 Total $ 28,000
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Example: The Effects of MarginExample: The Effects of Margin
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 is selling for $60 per share?
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 MarginExample: The Effects of Margin
KO is selling for $60 per share.
Your investment is worth $60,000.
You owe 6% on the $20,000 you borrowed: $1,200.
If you pay off the loan with interest, your account balance is: $60,000 – $21,200 = $38,800.
You started with $30,000.
Therefore, your return is $8,800 / $30,000 = 29.33%.
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 MarginExample: The Effects of Margin
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.
Your investment is now worth $36,000.
Therefore, your return is $6,000 / $30,000 = 20.00%.
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 Example: How Low Can it Go?Go?
Suppose you want to buy 300 shares of Pepsico, Inc. (PEP) at $55 per share.Total cost: $16,500You have only $9,900—so you must borrow
$6,600.
Your initial margin is $9,900/$16,500 = 60%.
Suppose your maintenance margin is 40%. At what price will you receive a margin call?
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Example: How Low Can it Go? Example: How Low Can it Go? (Answer)(Answer) This will happen when the price of Pepsico, Inc. drops to
$36.67. How so? Well,
$36.67.0.60
22
0.40 - 1 300
$6,600 P
here, So
Level Margin eMaintenanc - 1 Shares of Number
Borrowed Amount P
in results ,P price, stock critical the for Solving
P Shares of Number
Borrowed AmountPShares of Number Level Margin eMaintenanc
*
*
*
*
*
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Example: Annualizing Returns on a Margin Example: Annualizing Returns on a Margin PurchasePurchase
You buy 1,000 shares of Costco (COST) at $60 per share.
Your initial margin is 50%.
You borrow at the 9 percent call money rate plus 2 percent.
You sell Costco (COST) 4 months later for $63.
There were no dividends paid (and suppose the prices above are net of commissions).
What is your holding period percentage return and your EAR?
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Annualizing Returns on aAnnualizing Returns on a Margin Margin
PurchasePurchase Answer: First, you have to repay the 3-month loan, so t = (3/12 = .25)
Amount Repaid = Amount Borrowed × (1 + interest rate per year)t
Amount Repaid = $30,000 × (1 + .11).25
= $30,000 × 1.02643 = $30,792.90
Your Sale Proceeds = Cash from Sale – Amount Repaid = $63,000 – 30,792.90
= $32,207.10
Your Profit = Your Sale Proceeds – Your Investment = $32,207.10 - $30,000
= $2,207.10
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Annualizing Returns on a Margin Annualizing Returns on a Margin PurchasePurchase
32.85%. about is EAR yourSo
1.3285
0.0736) (1
Return) Percentage Period Holding (1 EAR 1
0.0736$30,000
$2,207.10
$30,000
$30,000 - $32,207.10 Return Percentage Period Holding
4
m
Note that there are 12/3 = 4 three-month holding periods in a year. Therefore, m = 4.
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Hypothecation and Street Name Hypothecation and Street Name RecognitionRecognition
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Hypothecation is the act of pledging securities as a collateral against a loan.
This pledge is needed so that the securities can be sold by the broker if the customer is unwilling or unable to meet a margin call.
Street name registration is an arrangement under which a broker is the registered owner of a security. (You, as the account holder are the “beneficial owner.”)
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Other Account IssuesOther Account Issues
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Trading accounts can also be differentiated by the ways they are managed.
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.
Discretionary account - You authorize your broker to trade for you.
Asset management account - Provide for complete money management, including check-writing privileges, credit cards, and margin loans.
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Other Account IssuesOther Account Issues
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To invest in financial securities, you do not need an account with a broker.
One alternative is to buy securities directly from the issuer.
Another alternative is to invest in mutual funds.
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Short SalesShort Sales
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• Short Sale is a sale in which the seller does not actually own the security that is sold.
Borrowsharesfrom
someone
Borrowsharesfrom
someone
Sell theShares in the market
Sell theShares in the market
Buyshares
From themarket
Buyshares
From themarket
Returnthe
shares
Returnthe
shares
Today In the Future
Note that an investor who buys and owns shares of stock is said to be “long the stock” or to have a “long position.”
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Short SalesShort Sales
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An investor with a long position benefits from price increases.Easy to understandYou buy today at $34, and sell later at $57,
you profit!Buy low, sell high
An investor with a short position benefits from price decreases.Also easy to understandYou sell today at $83, and buy later at $27,
you profit.Sell high, buy low
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Example: Short SalesExample: Short Sales
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You short 100 shares of Verizon Communications (VZ) at $30 per share.
Your broker has a 50% initial margin and a 40% maintenance margin on short sales.
The value of stock borrowed that will be sold short is: $30 × $100 = $3,000
Assets
Liabilities and Account Equity
Sale Proceeds $ 3,000 Short Position $ 3,000
Initial Margin Deposit $ 1,500 Account Equity $ 1,500
Total $ 4,500 Total $ 4,500
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Example: Short SalesExample: Short Sales
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Verizon Communications stock price falls to $20 per share.
Sold at $30, value today is $20, so you are "ahead" by $10 per share, or $1,000.
Also, new margin: $2,500 / $2,000 = 125%
AssetsLiabilities and
Account Equity
Sale Proceeds $ 3,000 Short Position $ 2,000
Initial Margin Deposit
$ 1,500 Account Equity $ 2,500
Total $ 4,500 Total $ 4,500
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Example: Short SalesExample: Short Sales
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Verizon Communications stock price rises to $40 per share.
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.Assets Liabilities and
Account Equity
Sale Proceeds $ 3,000 Short Position $ 4,000
Initial Margin Deposit $ 1,500 Account Equity $ 500
Total $ 4,500 Total $ 4,500
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More on Short SalesMore on Short Sales
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Short interest is the amount of common stock held in short positions.
In practice, short selling is quite common and a substantial volume of stock sales are initiated by short sellers.
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.
Short Sellers face Constraints. From government intervention Also, there might not be enough shares available to borrow to
short sell. Constraints reduce liquidity, increase volatility, and lead to
inefficient pricing.
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Finding Actual Short Positions (from Finding Actual Short Positions (from finance.yahoo.comfinance.yahoo.com))
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Forming a Real Investment Forming a Real Investment PortfolioPortfolio
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Take the Risk Tolerance Quiz in the textbook.
What score did you get?
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Forming a Real Investment Forming a Real Investment PortfolioPortfolioWhat does your score mean?
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Useful Internet SitesUseful Internet Sites
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www.finra.org (a reference for dispute resolution) www.bearmarketcentral.com (a reference for short selling) www.nasdaq.com (a reference for short interest) www.moneycentral.msn.com (a reference for building a
portfolio—search the site for “Build your first stock portfolio”)
www.sharebuilder.com (a reference for opening a brokerage account)
www.buyandhold.com (another reference for opening a brokerage account)
www.individual.ml.com (a risk tolerance questionnaire from Merrill Lynch)
www.money-rates.com (a reference for current broker call money rate)
finance.yahoo.com (a reference for short sales on particular stocks)
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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.
The various types of securities brokers Choosing a Broker Online Brokers Security Investors Protection
Corporation Broker-Customer Relations
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Chapter Review Chapter Review
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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
Forming a Real Investment Portfolio
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Chapter Review Chapter Review