copyright ©2004 pearson education, inc. all rights reserved. chapter 15 investing in stocks

Copyright ©2004 Pearson Education, Inc. All rights reserved.

Chapter 15

Investing in Stocks

Copyright ©2004 Pearson Education, Inc. All rights reserved. 15-2

Chapter Objectives

• Identify the functions of stock exchanges

• Explain how to execute the purchase or sale of stocks

• Discuss buying stocks on margin

• Explain how to assess your stock portfolio’s performance


Stock Exchange

• Stock exchanges: facilities that allow investors to purchase or sell existing stocks

• New York Stock Exchange– Most popular organized exchange in U.S.

– Floor traders: traders at a stock exchange who execute trades to fulfill orders placed by other investors


Stock Exchanges

– Specialists: traders who help to make a market in one or more stocks by taking the position opposite of orders placed by clients

• Other stock exchanges– American Stock Exchange

• Lists about 800 stocks that are generally smaller and less actively traded


Stock Exchanges

• Over-the-counter (OTC) market: an electronic communications network that allows investors to buy or sell securities– Market-makers: traders who execute trades

on the OTC market and earn commissions in the form of a bid-ask spread

– Less stringent listing requirements than for NYSE


Stock Exchanges

– Electronic Communication Networks (ECN): computer systems that match up desired purchases and sales of stocks

• Allow for after-hours trading

– Foreign stock exchanges facilitate investments in foreign securities

• American depository receipts: certificates representing ownership of foreign stocks


Purchasing or Selling Stocks

• Relying on brokerage or analyst recommendations– Evaluating analyst advice

• Brokers and analysts tend to be overly optimistic

• May encourage frequent trading to increase their commissions

• Should remind you of tax effects of selling



– Brokerage commissions• Discount brokerage firm: a brokerage firm that

executes your desired transactions but does not offer investment advice

• Full-service brokerage firm: a brokerage firm that offers investment advice and executes transactions


Financial Planning Online: Analyst Recommendations

• Go to: http://finance.yahoo.com/?u

• This Web site provides analyst recommendations about a stock that you specify. Type in the stock’s symbol, and then click on “Research.”

http://finance.yahoo.com/?u



• Buying or selling stock online– Low commissions

– Convenient


Financial Planning Online: Trading Stocks Online

• Go to: www.etrade.com

• Click on: About E*Trade

• This Web site provides information that you can use when making investment decisions. It also illustrates how you can trade stocks online, which typically reduces your transaction costs.

http://www.etrade.com/





• Placing an order– Name of the stock

• Ticker symbol: the abbreviated term that is used to identify a stock for trading purposes

– Buy or Sell — specify what you want to do


– Number of shares• Round lot: shares bought or sold in multiples of

100

• Odd lot: less than 100 shares of stock

– Market order or limit order• Market order: an order to execute a transaction to

buy or sell a stock at its prevailing market price

• Limit order: an order to execute a transaction to buy or sell a stock only if the price is within the limits that you specify



– Stop orders• Stop order: an order to execute a transaction

when the stock price reaches a specified level; a special form of limit order

• Buy stop order: an order for a brokerage firm to buy a stock when the price rises to a specified level

• Sell stop order: an order for a brokerage firm to sell a stock when the price falls to a specified level


Buying Stock on Margin

• On margin: purchasing a stock with a portion of the funds borrowed from a brokerage firm– Federal Reserve limits margin to 50 percent

– Margin call: a request from a brokerage firm for the investor to increase the cash in the account in order to bring the margin back up to the minimum level



• Impact of margin on returns

• Example– You want to buy 100 shares of Lynde stock, which

would require $50 per share, or $5,000. You purchase the 100 shares on margin by paying $3,000 in cash and borrowing $2,000 from the brokerage firm at an annual interest rate of 12%. After one year, you sell the stock for $60 per share, or $6,000, and repay the brokerage firm the amount borrowed plus interest. Lynde stock paid dividends of $1 per share, or $100 over the year.



• The return from buying a stock on margin is:

• Return = (S + D – I – LP)/I

S = proceeds from selling

D = dividends received over investment period

I = initial cash investment

LP = amount paid to broker to repay loan

• You borrowed $2,000, so your loan repayment is: LP = $2,000 x (1 + .12) = $2,400



• Your return on your investment is:

Return = (S + D – I – LP)/I

= ($6,000 + $100 – $3,000 – $2,240)/$3,000

= .2867 or 28.67%

• Without the loan, your return would have been

Return = (S + D – I)/I

= ($6,000 + $100 – $5,000)/$5,000

= .22 or 22%



• Impact of Margin on Risk

• Example: – Suppose that Lynde stock declines to $40

per share (instead of increasing to $60 per share) by the end of the year, so you receive $4,000 when you sell the stock. Your return is: (cont’d next slide)



Return = (S + D – I – LP)/I

= ($4,000 + $100 – $3,000 – $2,240)/$3,000

= –.38 or –38%

• Using all cash your return would be:

Return = ($4,000 + $100 – $5,000)/$5,000

= –.18 or –18%


Assessing Performance of Stock Investments

• Comparing returns to an index– A convenient method of measuring

performance

– Price quotations for indexes used to measure stock performance are reported in financial newspapers



Exhibit 15.1: Stock Performance Evaluation


Financial Planning Online:Stock Market Summary

• Go to: www.bloomberg.com

• Click on: “Markets”

• This Web site provides a summary of recent stock performance.

http://www.bloomberg.com/




Financial Planning Online: Stock Index Quotations

• Go to: http://finance.yahoo.com/m1?u

• This Web site provides recent quotations of indexes that can be used as benchmarks when assessing your investment portfolio’s performance. Click on “Charts” to review historical movements in any specific index.

http://finance.yahoo.com/m1?u


How Stock Investment Methods Fit Within Your Financial Plan

• Key decisions about investing in common stock for your financial plan are:– Should you consider buying stock?

– Which stocks should you purchase?

– What methods should you use for investing in stocks?


Integrating Key Concepts

Integrating Key Concepts

• Part 1: Financial Planning Tools

• Part 2: Liquidity Management

• Part 3: Financing

• Part 4: Protecting Your Assets and Income

• Part 5: Investing– In Chapter 13 we learned about investment fundamentals

– In Chapter 14 we learned about stock analysis and valuation

– In Chapter 15 we learned about investing in stocks

– In Chapter 16 we will learn about investing in bonds

– In Chapter 17 we will learn about investing in mutual funds

– In Chapter 18 we will cover asset allocation

• Part 6: Retirement and Estate Planning

copyright ©2004 pearson education, inc. all rights reserved. chapter 15 investing in stocks

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