Briefly discuss the relationship between investing and personal financial planning.

11-1 Briefly discuss the relationship between investing and personal financial planning.

Investing is generally considered to take a long-term perspective and is viewed as a process of purchasing securities wherein stability of value and level of return are somewhat predictable.

The best way to achieve financial objectives is through personal financial planning, which helps define our financial goals and develop appropriate strategies to reach them.

To obtain financial goals requires long term planning that includes investments plans as well as debt management, retirement planning, insurance planning, career management, family planning, and all of the other financial planning activities.  Investing is a major tool in providing the financial resources necessary to obtain your financial goals.

11-2 What’s the difference between an investment plan and a capital accumulation plan?

Capital accumulation, which is saving, is necessary in order to have funds to invest.  Investing is what you do with the capital you accumulate before you spend it to support your life style.

11-3 Why is it important to have investment objectives when embarking on an investment program?

There are a wide variety of securities available for investing.  Some provide annual income in the form of dividends.  Other provide increase wealth but no dividends.  Your goal for investing will guide you in your selection of alternative securities.

11-4 How does a primary market differ from a secondary market? Where are most securities traded: in the primary or the secondary market?

In the primary market, new securities are sold to the public, and one party to the transaction is always the issuer. In contrast, old (outstanding) securities are bought and sold in the secondary market, where the securities are “traded” between investors.

Securities are sold in the primary market only one time; they are sold many times in the secondary market.  The volume of sales in the secondary market overwhelms that in the primary market.

11-5 What is the difference between the broker and dealer markets?

Broker markets are the national and regional stock exchanges.  At the stock exchange the buyer and seller meet and exchange the stock.  The Dealer market does not have a central point where transactions are completed.  A dealer may be anywhere and will offer a stock for sale at the ask price, while another dealer will offer to buy at a bid price.  When the two prices are the same, a transaction takes place between the two dealers.  The dealers may be trading for themselves or for others.

11-6 What are regional exchanges, and what role do they play?

The regional exchanges operate much like the New York Stock Exchange.  They have brokers who tend to focus on local or regional stock, but who also will offer stock listed on the NYSE.  The listing requirements are more lenient than those of the NYSE, but since the stock being sold is from a regional company, the buyer presumably know more about the companies.

11-7 Describe the operations of the NASDAQ market. Compare it with an exchange, such as the NYSE.

To be traded on NASDAQ, all stocks must have at least two market makers—although the bigger, more actively traded stocks (such as Apple) will have many more than that. These dealers electronically post all their bid/ask prices so that, when investors place (market) orders, they’re immediately filled at the best available price.

With the broker market or the exchange, the buying and selling broker are at the exchange and strike a deal between them.  The brokers typically will be buying and selling for other people.

11-8 Contrast the NASDAQ and National Market System with the OTCBB.

NASDAQ sets various listing standards, the most comprehensive of which are for the 2,000 or so stocks traded on the NASDAQ National Market (NNM). 

The other part of the dealer market is made up of securities that trade in the over-the-counter (OTC) market. This market is separate from NASDAQ and includes mostly small companies that either can’t or don’t wish to comply with NASDAQ listing requirements. They trade on either the OTC Bulletin Board (OTCBB) or in the so-called Pink Sheets. The OTCBB is an electronic quotation system that links the market makers who trade the shares of small companies. The OTCBB is regulated by the Securities and Exchange Commission (SEC), which requires (among other things) that all companies traded on this market file audited financial statements and comply with federal securities law

11-9 Explain the difference between a bull market and a bear market. Discuss the frequency with which returns as bad as those during 2007–2009 occur. How would you characterize the current state of the stock market?

Prices go up in bull markets; these favorable markets are normally associated with investor optimism, economic recovery, and growth. In contrast, prices go down in bear markets, which are normally associated with investor pessimism and economic slowdowns.  Exhibit 11.2 reports the historical performance of U.S. stocks.  The table shows that over the past 50 years there have been more bull markets than bear markets.  In 2015, the market was volatile and most likely will end up as a bear market for the year.  The previous three years have been bull markets.

11-10 Describe the role that discount brokers play in carrying out security transactions.  To whom are their services especially appealing?

In contrast, investors who simply want to execute trades and aren’t interested in obtaining all those brokerage services should consider either a discount broker or an online broker. Discount brokers tend to have low-overhead operations and offer fewer customer services than do full-service brokers.  The full service brokers have repositioned themselves as money managers who buy and sell for their clients.  Most stock transactions are handled by discount brokers.

11-11 What are online brokers, and what kinds of investors are most likely to use them?

Again, most brokers have an online presence and low transaction fees.  Investors who manage their own investments tend to use online broker services.  Investors who use money managers to manage their investments do not use broker services directly.  Their money managers do.

11-12 What is the SIPC, and how does it protect investors?

As a client, you’re protected against the loss of securities or cash held by your broker by the Securities Investor Protection Corporation (SIPC), a nonprofit corporation authorized by the Securities Investor Protection Act of 1970 to protect customer accounts against the financial failure of a brokerage firm. Although subject to SEC and congressional oversight, the SIPC is not an agency of the U.S. government.

SIPC insurance covers each account for up to $500,000 (of which up to $100,000 may be in cash balances held by the firm). Note, however, that SIPC insurance does not guarantee that the dollar value of the securities will be recovered. It ensures only that the securities themselves will be returned.

11-13 What is arbitration? Does SIPC require the use of arbitration in investor disputes?

Arbitration is a process whereby you and your broker present the two sides of the argument before an arbitration panel, which then decides how the case will be resolved. If it’s binding arbitration, and it usually is, then you have no choice but to accept the decision—you cannot go to court to appeal your case.  SIPC is not involved in disputes concerning the quality of service provided; this is the type of cases that arbitration panels hear.  In fact, many brokerage firms require that you resolve disputes using binding arbitration.

11-14 Name and describe three basic types of orders.

An order to buy or sell a security at the best price available at the time it’s placed is a market order.

An order to buy at a specified price (or lower), or sell at a specified price (or higher) is known as a limit order.

An order to sell a stock when the market price reaches or drops below a specified level is called a stop-loss, or stop order.

11-15 Why might an investor buy securities on margin?

Buying on margin, as it’s called, is a practice that allows investors to use borrowed money to make security transactions.  The use of margin allows you to increase the return on your investment when stock prices increase.

11-16 Describe how the return on an investment is calculated.

Rate of return is the increase or decrease in the price of an investment as well as any income received over the investment period, both stated as a percentage of the initial investment.  It is calculated as:

                        Rate of Return =

11-17 What is a short sale? Explain the logic behind it. How much could be gained or lost on a short sale investment?

A short sale transaction is made in anticipation of a decline in the price of a stock. When an investor sells a security short, the broker borrows the security and then sells it on behalf of the short seller’s account—short sellers actually sell securities they don’t own. The borrowed shares must, of course, be replaced in the future, and if the investor can repurchase the shares at a lower price, then a profit will result.

11-18 Briefly discuss the four basic types of information that you, as an investor, should follow.

Here are the four types of investment information that you should follow on a regular basis:

• Economic developments and current events: To help you evaluate the underlying investment environment

• Alternative investment vehicles: To keep you abreast of market developments

• Current interest rates and price quotations: To monitor your investments and stay alert for developing investment opportunities

• Personal investment strategies: To help you hone your skills and stay alert for new techniques as they develop

11-19 What role do market averages and indexes play in the investment process?

Usually presented in the form of averages, or indexes, market data describe the general behavior of the securities markets. The averages and indexes are based on the price movements of a select group of securities over an extended period. They’re used to capture the overall performance of the market as a whole.  They also may be used as a standard to compare against your performance, that is, are you beating the market?  Most likely not.

11-20 Briefly describe the DJIA, S&P 400, S&P 500, NASDAQ Composite, Russell 2000, and Dow Jones Wilshire 5000 indexes. Which segments of the market does each measure track?

Dow Jones Industrial Average (DJIA). The Dow Jones averages, which began in 1896, are made up of four parts: (1) an industrial average, the DJIA, which is based on 30 stocks; (2) a transportation average based on 20 stocks; (3) a utility average based on 15 stocks; and (4) a composite average based on all 65 industrial, transportation, and utility stocks.

A variation of the S&P discussed below is a the MidCap 400 (made up of 400 medium-sized companies with market values ranging from about $1.4 billion to $5.9 billion).

The Standard & Poor’s (S&P) indexes are similar to the Dow Jones averages in that both are used to capture the overall performance of the market. However, some important differences exist between the two measures. For one thing, the S&P uses a lot more stocks: the popular S&P 500 composite index is based on 500 different stocks, whereas the DJIA uses only 30. What’s more, the S&P index is made up of all large NYSE stocks in addition to some major AMEX and NASDAQ stocks, so there are not only more issues in the S&P sample but also a greater breadth of representation. Finally, there are some technical differences in the mathematical procedures used to compute the two measures; the Dow Jones is an average, whereas the S&P is an index.

Behavior in the NASDAQ market is also measured by several indexes, the most comprehensive of which is the NASDAQ Composite index, which is calculated using virtually all the stocks traded on NASDAQ.

A widely followed measure is the Russell 2000, which tracks the behavior of 2,000 relatively small companies and is widely considered to be a fairly accurate measure of the small-cap segment of the market.

Besides these major indexes, there are a couple of other measures of market performance, one of which is the Dow Jones Wilshire 5000 index. It’s estimated that the Wilshire index reflects the total market value of 98 percent to 99 percent of all publicly traded stocks in the United States. In essence, it shows what’s happening in the stock market as a whole—the dollar amount of market value added or lost as the market moves up and down.

11-21 Describe the Internet’s impact on the world of investing.

The Internet is a major force in the investing environment. It has opened the world of investing to individual investors, leveling the playing field and providing access to tools and market information formerly restricted to professionals. Not only can you trade all types of securities online, you can also find a wealth of information, from real-time stock quotes to securities analysts’ research reports.  The internet adds access and speed to the investing process.

11-22 What are some products and services that you, as an individual investor, can now obtain online?

Whatever there is, it is available online.  Some commonly available stuff include brokerage services, reports, “heard on the street”, business news, and many other.  Brands include CNN/Money, Yahoo.com, Fidelity.com, etc.

11-23 Briefly describe several types of online investment tools, and note how they can help you become a better investor.

The Internet offers a wide array of tutorials, online classes, and articles to educate the novice investor. Even experienced investors will find sites that expand their investing knowledge. Although most good investment-oriented Web sites include many educational resources, here are a few good sites featuring investment fundamentals.

• The Motley Fool (http://www.fool.com) Fool’s School has sections on fundamentals of investing, mutual fund investing, choosing a broker, investment strategies and styles, lively discussion boards, and more.

• Morningstar (http://www.morningstar.com) provides comprehensive information on stocks, mutual funds, ETFs, and more.

• Zacks Investment Research (http://www.zacks.com) is an excellent starting place to learn what the Internet can offer investors.

• NASDAQ (http://www.nasdaq.com) has an Investor Resource section that helps with financial planning and choosing a broker.

Other good educational sites include, as noted above, leading personal finance magazines like Money (http://money.cnn.com) and Kiplinger’s Personal Finance Magazine (http://www.kiplinger.com).

11-24 What is day trading, and how is it different from the more traditional approach to investing?

The attraction of trading stocks online is so compelling that some investors have become day traders. The opposite of buy-and-hold investors with a long-term perspective, day traders buy and sell stocks quickly throughout the day. They hope their stocks will continue to rise in value for the short time they own them—sometimes just seconds or minutes—so they can make quick profits.

11-24 Explain why it might be preferable for a person to invest in a portfolio of securities rather than in a single security.

Don’t put all your eggs in one basket.  In essence, a portfolio is a collection of investment vehicles assembled to meet a common investment goal. But a portfolio is far more than a collection of investments. It breathes life into your investment program as it combines your personal and financial traits with your investment objectives to give some structure to your investments.  Seasoned investors often devote much attention to constructing diversified portfolios of securities. Such portfolios consist of stocks and bonds selected not only for their returns but also for their combined risk–return behavior. The idea behind diversification is that, by combining securities with dissimilar risk–return characteristics, you can produce a portfolio of reduced risk and more predictable levels of return.

11-25 Briefly describe the concept of asset allocation and note how it works.

The investor’s needs shape one’s financial goals. But to create a portfolio geared to those goals, you need to develop an asset allocation strategy. Asset allocation involves a decision on how to divide your portfolio among different types of securities.  Typically you are dividing your investment between short-term securities such as money market funds, longer term bonds (7 to 10 year maturities, and equity funds invested in stocks for the long-term.

11-26 Discuss the role of asset allocation in portfolio management.

There’s overwhelming evidence that, over the long run, the total return on a portfolio is influenced far more by its asset allocation plan than by specific security selections.  Asset allocation deals in broad categories and does not tell you which individual securities to buy or sell.

11-27 What, if anything, can be gained from keeping track of your investment holdings?

Knowledge is power.  If you do not know how you are doing, you do not if you need to make a change in what you are doing.   You need to monitor your portfolio  by keeping track of what your investment holdings consist of, how they’ve performed over time, and whether they’ve lived up to your expectations.