Bob LeClair's Finance and Markets NewsletterChange Change

1/1/14 1/11/14 1/18/14 (Week) (Yr-to-Date)Dow Jones Ind. Avg. 16,577 16,437 16,459 22 (118)

(% Change) 0.13% -0.71%S & P 500 Index 1,848 1,842 1,839 (4) (10)

(% Change) -0.20% -0.52%NASDAQ Composite 4,177 4,175 4,198 23 21

(% Change) 0.55% 0.50%

S & P 500 P/E Ratio 19.0 19.0 18.9 0.0 -0.1S & P 500 Div. Yield 1.94% 1.91% 1.92% 0.01% -0.02%T-bill - S&P 500 Yield -1.87% -1.86% -1.89% -0.03% -0.02%

30-Year T-Bond Yield 3.97% 3.80% 3.75% -0.05% -0.22%10-Year T-Bond Yield 3.03% 2.86% 2.82% -0.04% -0.21%91-Day T-Bill Yield 0.07% 0.06% 0.03% -0.03% -0.04%Yield Spread 3.90% 3.75% 3.72% -0.03% -0.18%

30-Year Mortgage 4.48% 4.51% 4.41% -0.10% -0.07%15-Year Mortgage 3.52% 3.56% 3.45% -0.11% -0.07%1-Year Adjustable Rate 2.56% 2.56% 2.56% 0.00% 0.00%30-Yr. - 1-Yr. ARM Rate 1.92% 1.95% 1.85% -0.10% -0.07%

$ Value of Euro (€) $1.3754 $1.3665 $1.3541 -$0.0124 -$0.0213Japanese Yen (¥/$) 105.33 104.17 104.32 0.15 -1.01Crude Oil, Spot Price $98.42 $91.66 $94.37 $2.71 -$4.05Gasoline, Reg. ($/Gal.) $3.32 $3.31 $3.29 -$0.02 -$0.03

For the Week Ending:

Finance & Markets NewsletterWeekly Data Table

• www.leimberg.com

• Free Resources

• Bob LeClair’s Finance and Markets Newsletter

Assignment

• Calculate the compound annual return (geometric mean) of the Standard & Poor’s 500 Stock Index for the period 2004-2013.

• S&P 500 Return2004-2013 = ???

S & P 500 Annual ReturnsYear Total Return (%)

2004 +10.88

2005 + 4.91

2006 +15.79

2007 + 5.49

2008 - 37.00

2009 +26.46

2010 +15.06

2011 + 2.05

2012 +16.00

2013 +32.40

         

    Holding     

  Period Adjusted 

  Return Return

Year   (HPR)   (1.0+HPR)

2004 0.1088 1.1088

2005 0.0491 1.0491

2006 0.1579 1.1579

2007 0.0549 1.0549

2008 -0.3700 0.6300

2009 0.2646 1.2646

2010 0.1506 1.1506

2011 0.0205 1.0205

2012 0.1600 1.1600

2013  0.3240  1.3240

Product of Adjusted HPRs 2.0414

   

10th Root of Product   1.0740

   

Geometric Mean   7.40%

YearS & P 500

Total Return (%)Ending

Value ($)

2004 +10.88

2005 + 4.91

2006 +15.79

2007 + 5.49 1,000.00

2008 -37.00

2009 +26.46

2010 +15.06

2011 + 2.05

2012 +16.00

2013 +32.40 9

YearS & P 500

Total Return (%)Ending

Value ($)

2004 +10.88

2005 + 4.91

2006 +15.79

2007 + 5.49 1,000.00

2008 -37.00 630.00

2009 +26.46

2010 +15.06

2011 + 2.05

2012 +16.00

2013 +32.40 10

YearS & P 500

Total Return (%)Ending

Value ($)

2004 +10.88

2005 + 4.91

2006 +15.79

2007 + 5.49 1,000.00

2008 -37.00 630.00

2009 +26.46 796.70

2010 +15.06 916.68

2011 + 2.05 935.48

2012 +16.00 1,085.15

2013 +32.40 1,436.74 11

Chapter

The Investment Process

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2

Problems: Chapter 2

• 2.19

• 2.20

• 2.25

2-15

Learning Objectives

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.

2-16

Investing Overview• 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 strategies– Two parts

• Objectives• Constraints

2-17

Objectives: 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

2-18

Investor Constraints

• Resources. What is the minimum sum needed? What are the associated costs?

• Horizon. When do you need the money?

• Liquidity. How high is the possibility that you need to sell the asset quickly?

• Taxes. Which tax bracket are you in?

• Special circumstances. Does your company provide any incentive? What are your regulatory and legal restrictions?

2-19

Investment Strategies and Policies

• Investment management. Should you manage your investments yourself?

• 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?

• Security selection. Within each class, which specific securities should you buy?

2-20

Asset Allocation or Security Selection?

• 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

2-24

Choosing a Broker/Advisor, I.

• What do you do after carefully crafting your Investment Policy Statement (IPS)?

• 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:

1. full-service brokers

2. discount brokers

3. deep-discount brokers

• These three groups can be distinguished by the level of service provided, as well as the level of commissions charged.

2-25

Choosing a Broker/Advisor, II.• 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.

2-26

Advisor-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.

2-27

Securities Investor Protection Corporation

• Securities Investor Protection Corporation (SIPC): Insurance fund covering investors’ brokerage accounts when member firms go bankrupt or experience financial difficulties.

• Most brokerage firms belong to the SIPC, which insures each account for up to $500,000 in cash and securities, with a $100,000 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.

2-29

Two 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)

2-30

Margin 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.

2-31

Example: Margin Accounts,The Balance Sheet

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

• 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%

2-32

Margin 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.

2-33

Example: The Workings of a Margin Account, I.

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

• 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.

2-34

Example: The Workings of a Margin Account, II.

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

• 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.

JMD: Problem 2-19 (pp. 77)

• Suppose you hold a particular investment for 7 months. You calculate that your holding period return (HPR) is 6%. What is your annualized return?

JMD: Problem 2-19 (pp. 77)

• 1 + EAR = (1.06)12/7 = 1.1050

• EAR = 10.50%

JMD: Problem 2-20 (pp.77)

• In the previous question, suppose your holding period was 5 months instead of 7. What is your annualized return?

JMD: Problem 2-20 (pp. 77)

• 1 + EAR = (1.06)12/5 = 1.1501• EAR = 15.01%• What do you conclude in general

about the length of your holding period and your annualized return?

• 12 ÷ 7 = 1.7• 12 ÷ 5 = 2.4

2-47

Hypothecation and Street Name Registration

• 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.”)

2-48

Other Account Issues, I.• 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.

2-50

Short Sales, I.

Note that an investor who buys and owns shares of stock is said to be “long the stock” or to have a “long position.”

• 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

51

Long vs. Short Trades

BuyLow[-]

SellHigh[+]

Time

Long Trade – you own

Bob LeClair's Finance and Markets NewsletterChange Change

1/1/14 1/18/14 1/25/14 (Week) (Yr-to-Date)Dow Jones Ind. Avg. 16,577 16,459 15,879 (579) (698)

(% Change) -3.52% -4.21%S & P 500 Index 1,848 1,839 1,790 (48) (58)

(% Change) -2.63% -3.14%NASDAQ Composite 4,177 4,198 4,128 (69) (48)

(% Change) -1.65% -1.16%

S & P 500 P/E Ratio 19.0 18.9 18.2 -0.7 -0.8S & P 500 Div. Yield 1.94% 1.92% 1.93% 0.01% -0.01%T-bill - S&P 500 Yield -1.87% -1.89% -1.88% 0.01% -0.01%

30-Year T-Bond Yield 3.97% 3.75% 3.63% -0.12% -0.34%10-Year T-Bond Yield 3.03% 2.82% 2.72% -0.10% -0.31%91-Day T-Bill Yield 0.07% 0.03% 0.05% 0.02% -0.02%Yield Spread 3.90% 3.72% 3.58% -0.14% -0.32%

30-Year Mortgage 4.48% 4.41% 4.39% -0.02% -0.09%15-Year Mortgage 3.52% 3.45% 3.44% -0.01% -0.08%1-Year Adjustable Rate 2.56% 2.56% 2.54% -0.02% -0.02%30-Yr. - 1-Yr. ARM Rate 1.92% 1.85% 1.85% 0.00% -0.07%

$ Value of Euro (€) $1.3754 $1.3541 $1.3678 $0.0137 -$0.0076Japanese Yen (¥/$) 105.33 104.32 102.31 -2.01 -3.02Crude Oil, Spot Price $98.42 $94.37 $97.32 $2.95 -$1.10Gasoline, Reg. ($/Gal.) $3.32 $3.29 $3.29 $0.00 -$0.04

For the Week Ending:

53

Long vs. Short Trades

BuyLow[-]

SellHigh[+]

Time

BuyLow[-]

SellHigh[+]

Long Trade – you own

Short Sale – you owe

2-54

Short Sales, II.

• An investor with a long position benefits from price increases.

– Easy to understand

– You 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 understand

– You sell today at $83, and buy later at $27, you profit.

– Sell high, buy low

JMD: Problem 2-25 (pp. 77)

• You just sold short 750 shares of Wetscope, Inc., a fledgling software firm, at $96 per share. You cover your short when the price hits $86.50 per share one year later. If the company paid $0.75 per share in dividends over this period, what is your rate of return on the investment? Assume an initial margin of 60%.

JMD: Problem 2-25 (pp. 77)

• Proceeds from short sale= $72,000

• Initial margin deposit (60%) = $43,200

• Cost of covering short = $64,875

• Cost of covering dividends = $562.50

• Dollar profit = $72,000 – $64,875 - $562.50 = $6,562.50

• Return (%) = $6,562.50 ÷ $43,200 = 15.19%

2-60

More on Short Sales

• 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 (i.e., the SEC)

– Also, there might not be enough shares available to borrow to short sell.

– Constraints reduce liquidity, increase volatility, and lead to inefficient pricing.

2-64

Useful Internet Sites

• 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)