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Slides by Pamela L. Hall

Western Washington University

Buying and Selling Securities

Chapter 13

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Classifying Today’s Investment AlternativesDirect investing

You actually own the investment Types of direct investments

Fixed-income securities Stocks Real estate Exotic investments (options, futures, real assets,

collectibles)

Indirect investing You own shares in an investment company

(typically a mutual fund) that actually owns the investment

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Fixed-Income SecuritiesYou are lending money to the issuer of the security

(can be a corporation, the government, etc.)Characteristics

You would buy the fixed-income security because the issuer promises to pay you a fixed amount of interest income every period

The security will mature at some point and you will receive par, or face value, at that point

If the issuer fails to make interest or principal payments when due, you have certain legal rights as a lender Known as default risk

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Money-Market Instruments

Mature within one year of issuanceTypically sold at a discountLow risk (in terms of default)Large face values ($100,000 to $1 mil)

Probably never buy a money market security directly

T-bills have small face values ($10,000)

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Bonds (Long-Term, Fixed-Income Securities)

Up to a 30-year maturity dateMost bonds pay a periodic, fixed amount of

interest (income to you)Most bonds are callable

Gives issuer right to buy back the bondsBonds vary widely in terms of default riskHow much default risk a bond has depends

on the issuer U.S. government, municipality, corporation

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Bonds (Long-Term, Fixed-Income Securities)

Treasury Notes and Bonds Issued by U.S. Treasury Maturities range from 2 to 30 years Fixed coupon rates No default risk Interest is exempt from state (not

federal) income taxes

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Bonds (Long-Term, Fixed-Income Securities)Municipal Bonds

Issued by state and local government units Used for public projects such as building a new school,

repairing highways Types of munis

Revenue—only the revenue generated from the project for which bonds were issued is used to pay income on bond

General obligation bond—backed by the “full faith and credit” of the state

Interest income is exempt from federal income taxes Many are rated by bond rating companies

Standard & Poors Moodys

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Bonds (Long-Term, Fixed-Income Securities)

Corporate bonds Issued by corporations to finance

expansion, etc. Vary widely in terms of collateral and

repayment provisions Vary widely in terms of default risk Interest income is subject to federal and

state taxes

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What Determines Bond Prices?Price of bond is present value of future

expected cash flows The higher the discount rate used to find the present

value, the lower the present value, and vice versa It is possible for a bond to sell at a price above

or below face value Depends on the interest rate used to discount the

bond’s future cash payments Known as yield to maturity

A bond’s yield to maturity changes as market interest rates change

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Stock InvestingAs a stockholder, you actually own a portion of

a companyYou have voting rights (vote for members of the

Board of Directors who oversee management who run the company)

Why invest in common stock? As a bondholder you are promised a fixed income

(interest) regardless of how well or poorly the firm performs

As a stockholder, as the firm profits, you profit through either dividends or stock price increase (or both)

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Stock Investing

Dividends represent cash payments from a firm to its stockholders Not guaranteed Can be eliminated, increased, decreased Some firms pay dividends, some don’t

As a stockholder, you want to see a firm’s stock price rise, as you would benefit when you sold the stock

Most of a stockholder’s return comes in the form of an increase in stock price

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Types of Common Stock Blue chip: companies with a long record of stable

earnings and dividend growth, financially strong Growth Stocks: firms experiencing rapid sales and

earnings growth (& this growth is expected to continue)

Income stocks: stocks that produce most of the return to stockholders in the form of dividends, rather than price appreciation (utility companies)

Speculative stocks: risky as they may do quite well, or quite poorly

Cyclical vs Defensive stocks: stocks that move with, or against (or have little relationship with) the market

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Valuing Common StocksHow much should you be willing to pay for this

stock? If you own it already, at what price should you

sell it?Subjective component:

Stock A is currently selling for $46 To some, this is a good purchase price To others, it is not…

Different people use different valuation techniques Technicians vs fundamentalists

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Valuing Common Stocks

In general, the following factors affect a stock’s price Company earnings Company dividends Expected growth rate in company’s

future earnings and dividends Uncertainty over above growth rate Interest rates

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Web Links

Lots of information available on web:

http://www.investor.msn.com

http://www.smithbarney.com

http://www.zacks.comhttp://www.multex.com

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Some Important Numbers Return on Equity—aftertax profits ÷ stockholder equity

Measures return to stockholders An ROE of 15 is considered average

Earnings per share—aftertax profits ÷ number of outstanding shares

Price-to-earnings ratio—current stock price ÷ company’s earnings

Some people dislike stocks with above average P/E ratios

Beta—measures how risky a stock is relative to the overall market

Betas > (<) 1.0 are considered more (less) risky than overall market

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Choosing the Right Stock for You

Does the stock fit into your overall investment plan in terms of Goals Risk tolerance

Don’t forget to diversify

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Understanding Financial MarketsU.S. financial markets are fair, open and

orderly Trades occur in full view of all market participants Information is available as to the number of

buyers and sellers (important because supply and demand determine market prices)

Assuming no new pertinent information, one can place a trade at or near the last trade price

Transaction costs are low (commissions) All participants have equal access to the market Prices adjust quickly to new public information

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Types of Financial Markets

Primary vs SecondaryWhere trading takes place

Physical location—trading floor Via computers (over-the-counter markets)

Examples of Financial Markets NYSE

Trading floor NASDAQ

Computer-based network

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Selecting a Brokerage Firm and a Broker Do you want full service?

Offer investment advice Record keeping Access to analysts’ reports Provide list of recommended securities Normally deal with a specific person who is your broker (and

paid on commission)

Do you want discount service? Mainly provides order execution & record keeping Most provide information from independent sources (for a fee) Broker works via salary, you deal with no specific person

Do you want deep discount service? Provide order execution and record keeping and little else

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Selecting a Brokerage Firm and a Broker

The main difference is in the area of advice and how much you pay Are you an inexperienced investor AND Do you think an experienced investment

professional can consistently earn you more than if you invested in the stock market in general?

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Selecting a Stockbroker Remember, with a full service firm, the stockbroker is

paid on commission (and receives a higher commission on some items compared to others)

Before you select a broker, set your financial goals, time horizon, and your tolerance for risk

Interview several brokers at several firms Ask about their experience, educational background, typical client

Check the broker’s background and licenses Make certain that the broker clearly explains the commission he’ll

receive for specific products Don’t submit to pressure! Be wary of unsolicited calls (cold calls)

NEVER buy a security from a cold call—ALWAYS ask for written information about the investment and check that investment via other sources.

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Types of Orders and Trades

Market Order Order to trade at the best possible price

for you Lowest (highest) if you are buying (selling)

Most are filled within 1 minute of the time you place the order

Limit Orders Establishes a floor (as a seller) or ceiling

(as a buyer) for stock price

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Investment Record Keeping

Extremely important Taxes

Dividends Capital gains/losses Commissions are tax deductible, but you need

to have the records for proof Track your performance Update records at least quarterly Will receive monthly statements from

broker