PART 4:MANAGING YOUR INVESTMENTS

Chapter 13Chapter 13

Investing in Stocks Investing in Stocks

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Why Consider Stocks?Why Consider Stocks?

When you buy common stock, you When you buy common stock, you purchase a part of the company.purchase a part of the company.

Returns come from:Returns come from: Dividends - the company’s distribution Dividends - the company’s distribution

of profits to stockholders.of profits to stockholders. Capital appreciation - the increase in Capital appreciation - the increase in

the selling price of a share of stock.the selling price of a share of stock.

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Why Consider Stocks?Why Consider Stocks?

Neither dividends nor capital Neither dividends nor capital appreciation is guaranteed with appreciation is guaranteed with common stock.common stock.

Dividends are paid at the board’s Dividends are paid at the board’s discretion.discretion. Can be cash or additional stock.Can be cash or additional stock.

Capital appreciation takes place Capital appreciation takes place when the company does well. when the company does well.

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Why Consider Stocks?Why Consider Stocks?

Over time, common stocks Over time, common stocks outperform all other investments.outperform all other investments.

Stocks reduce risk through Stocks reduce risk through diversification.diversification.

Stocks are liquid.Stocks are liquid. Growth is determined by more than Growth is determined by more than

interest rates.interest rates.

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The Language of The Language of Common StocksCommon Stocks

Limited Liability – in case of bankruptcy, Limited Liability – in case of bankruptcy, loss limited to amount of investment.loss limited to amount of investment.

Claim on Income – receive earnings Claim on Income – receive earnings after debt holders and preferred after debt holders and preferred stockholders.stockholders. Earnings distributed through dividends or Earnings distributed through dividends or

reinvested into company.reinvested into company. Quarterly dividends are not automatic – they Quarterly dividends are not automatic – they

must be declared by board of directors.must be declared by board of directors.

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The Language of The Language of Common StocksCommon Stocks

Claims on Assets – paid after all Claims on Assets – paid after all creditors.creditors.

Voting Rights – elect board of directors, Voting Rights – elect board of directors, approve changes in corporation’s rules.approve changes in corporation’s rules. Voting done in person or by proxy.Voting done in person or by proxy.

Stock Splits – substitute more shares for Stock Splits – substitute more shares for existing ones, thereby lowering the price.existing ones, thereby lowering the price.

No immediate gain in wealth for stockholder. No immediate gain in wealth for stockholder.

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The Language of The Language of Common StocksCommon Stocks

Stock Repurchases – company buys Stock Repurchases – company buys back its own stock. back its own stock.

Book Value – subtract firm’s Book Value – subtract firm’s liabilities from assets.liabilities from assets.

Earnings Per Share – level of Earnings Per Share – level of earnings for each share of stock. earnings for each share of stock. Compares performance of different Compares performance of different

companies. companies.

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The Language of The Language of Common StocksCommon Stocks

Dividend Yield – amount of annual Dividend Yield – amount of annual dividend divided by market price of dividend divided by market price of stock. stock. Calculates return if stock price and Calculates return if stock price and

dividend are unchanged. dividend are unchanged.

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Stock Market IndexStock Market Index

Is a measure of the performance of a Is a measure of the performance of a group of stocks that represent the group of stocks that represent the market or a sector of the market.market or a sector of the market. Dow JonesDow Jones S&P 500S&P 500

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The DowThe Dow

The Dow Jones Industrial Average The Dow Jones Industrial Average (DJIA or Dow) is the oldest and most (DJIA or Dow) is the oldest and most widely quoted index.widely quoted index.

Created by Charles Dow in 1896 to Created by Charles Dow in 1896 to gauge the well-being of the market, gauge the well-being of the market, was based on 12 companies. was based on 12 companies.

Dow currently has 30 stocks, with Dow currently has 30 stocks, with GE the only original Dow component.GE the only original Dow component.

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The S&P 500 and Other The S&P 500 and Other IndexesIndexes

The Standard and Poor’s 500 Stock Index The Standard and Poor’s 500 Stock Index is broader than the DJIA. It may better is broader than the DJIA. It may better represent the market’s movements.represent the market’s movements.

The Russell 1000 is comprised of the 1000 The Russell 1000 is comprised of the 1000 largest companies.largest companies.

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Market MovementsMarket Movements

A bear market is characterized by A bear market is characterized by falling prices.falling prices.

A bull market has rising prices.A bull market has rising prices.

Names come from how the animals Names come from how the animals attack: attack: Bears swipe downward with their paws.Bears swipe downward with their paws. Bulls fling their horns upward.Bulls fling their horns upward.

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General ClassificationsGeneral Classificationsof Common Stockof Common Stock

Blue-Chip Stocks – issued by large, Blue-Chip Stocks – issued by large, nationally-known companies with nationally-known companies with sound financials, solid dividend and sound financials, solid dividend and growth records. growth records. GE and P&G are examples.GE and P&G are examples.

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General ClassificationsGeneral Classificationsof Common Stockof Common Stock

Growth Stocks – companies with Growth Stocks – companies with sales and earnings growth well sales and earnings growth well above their industry average. above their industry average. Microsoft is an example.Microsoft is an example.

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General ClassificationsGeneral Classificationsof Common Stockof Common Stock

Income Stocks – mature firms paying Income Stocks – mature firms paying high dividends with little increase in high dividends with little increase in earnings.earnings.

Speculative Stocks – carry more risk Speculative Stocks – carry more risk and variability, difficult to forecast, and variability, difficult to forecast, and traded on the OTC.and traded on the OTC.

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General ClassificationsGeneral Classificationsof Common Stockof Common Stock

Cyclical Stocks – earnings move with Cyclical Stocks – earnings move with the economy, dropping during a the economy, dropping during a recession.recession.

Defensive Stocks – are not nearly as Defensive Stocks – are not nearly as affected by economic swings, and affected by economic swings, and perform better during a downturn. perform better during a downturn. Examples include insurance and auto Examples include insurance and auto

parts firms.parts firms.

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General ClassificationsGeneral Classificationsof Common Stockof Common Stock

Large caps, mid caps, and small caps – Large caps, mid caps, and small caps – refer to the size of the issuing company refer to the size of the issuing company – its level of capitalization or market – its level of capitalization or market value.value. From 1926-2004, small-cap stocks From 1926-2004, small-cap stocks

outperformed large-cap stocks.outperformed large-cap stocks.

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The Price/Earnings The Price/Earnings ApproachApproach

The price/earnings ratio measures a The price/earnings ratio measures a stock’s relative value.stock’s relative value.

The P/E ratio = price per share/epsThe P/E ratio = price per share/eps It indicates how much investors are It indicates how much investors are

willing to pay for a dollar of the willing to pay for a dollar of the company’s earnings. company’s earnings.

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The Price/Earnings The Price/Earnings ApproachApproach

The more positive investors feel The more positive investors feel about a stock, the higher the P/E about a stock, the higher the P/E ratio.ratio.

A P/E ratio of 20 means it is “selling A P/E ratio of 20 means it is “selling at 20 times earnings.” at 20 times earnings.”

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Be AlertBe Alert

Checklist 13.2Checklist 13.2 Look out for:Look out for:

Recommendations based on inside or Recommendations based on inside or confidential information.confidential information.

Telephone sales pitches.Telephone sales pitches. Representations of spectacular profit.Representations of spectacular profit. Guarantees you will not lose money.Guarantees you will not lose money. An excessive number of transactions.An excessive number of transactions. Pressure to trade in an inconsistent Pressure to trade in an inconsistent

manner. manner.

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Dollar Cost AveragingDollar Cost Averaging

Purchasing a fixed dollar amount of Purchasing a fixed dollar amount of stock at specified intervals.stock at specified intervals.

Same dollar amount each period will Same dollar amount each period will average out the fluctuations.average out the fluctuations.

Buy more shares at a lower price, Buy more shares at a lower price, fewer shares at higher prices. fewer shares at higher prices.

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Buy and HoldBuy and Hold

Involves buying stock and holding it Involves buying stock and holding it for a period of years.for a period of years.

Why consider this?Why consider this? Avoids timing the market.Avoids timing the market. Minimizes brokerage fees and Minimizes brokerage fees and

transaction costs.transaction costs. Postpones capital gains taxes.Postpones capital gains taxes. Gains taxed as long-term capital gains. Gains taxed as long-term capital gains.

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Dividend ReinvestmentDividend ReinvestmentPlans (DRIPs)Plans (DRIPs)

Automatically reinvest the dividends in Automatically reinvest the dividends in the firm’s stock without brokerage the firm’s stock without brokerage fees.fees.

Use a DRIP to reinvest rather than Use a DRIP to reinvest rather than spend your dividends. spend your dividends.

Even though you don’t receive any Even though you don’t receive any cash when the dividends are cash when the dividends are reinvested, you still need to pay reinvested, you still need to pay income taxes.income taxes.

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Risks Associated withRisks Associated withCommon StocksCommon Stocks

The Risk-Return Trade-offThe Risk-Return Trade-off Without the risks, we would not Without the risks, we would not

expect the high returns that common expect the high returns that common stocks offer.stocks offer.

A great deal of potential risk if the A great deal of potential risk if the firm does poorly, a great deal of firm does poorly, a great deal of reward if it does well.reward if it does well.

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Risks Associated withRisks Associated withCommon StocksCommon Stocks

Diversification Reduces RiskDiversification Reduces Risk In a well-diversified portfolio, only In a well-diversified portfolio, only

systematic risk remains.systematic risk remains. As a portfolio increases to 10-20 As a portfolio increases to 10-20

stocks, 60% of total risk is stocks, 60% of total risk is eliminated.eliminated.

Measure systematic risk using Measure systematic risk using ((ββ)eta)eta..

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Principles AssociatedPrinciples Associatedwith Common Stockswith Common Stocks

Diversification Reduces RiskDiversification Reduces Risk ββeta for the market = 1eta for the market = 1 ββeta > 1 means the stock has above eta > 1 means the stock has above

average systematic risk.average systematic risk. ββeta < 1 means the stock has below eta < 1 means the stock has below

average systematic risk.average systematic risk.

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Principles AssociatedPrinciples Associatedwith Common Stockswith Common Stocks

The Time Dimension of InvestingThe Time Dimension of Investing One year returns are quite variable, One year returns are quite variable,

making short-term investments risky. making short-term investments risky. As investment horizons increase, invest As investment horizons increase, invest

in riskier assetsin riskier assets.. In the long-term, you’ll do better with In the long-term, you’ll do better with

stocks rather than other investments.stocks rather than other investments. Investors can take more long-term risks Investors can take more long-term risks

because they have more time to adjust because they have more time to adjust their consumption and work habits.their consumption and work habits.

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Understanding the Understanding the ConceptConcept

of Leverageof Leverage Borrowing the money you invest can Borrowing the money you invest can

affect your investment return. affect your investment return. Leverage refers to the use of Leverage refers to the use of

borrowed funds to increase borrowed funds to increase purchasing power.purchasing power. Leverage magnifies the gains and the Leverage magnifies the gains and the

losses. losses.