Chapter 4 Investment Vehicles Debt Investments Certificates of Deposit and Cash Equivalents Commercial banks and other institutions offer a variety of savings certificates known as certificates of deposit (CDs). These certificates are available for various maturities, with higher rates offered as maturity increases. (Larger deposits may also command higher rates, holding maturity constant.) In effect, institutions are free to set their own rates and terms on most CDs. Because of competition for funds, the terms on CDs have been liberalized. Although some CD issuers have now reduced the stated penalties for early withdrawal, and even waived them, penalties for early withdrawal of funds can be, and often are, imposed. Money markets include short-term, highly liquid, relatively low-risk debt instruments sold by governments, financial institutions, and corporations to investors with temporary excess funds to invest. This market is dominated by financial institutions, particularly banks, and governments. The size of the transactions in the money market typically is large ($100,000 or more). The maturities of money market instruments range from one day to one year and are often less than 90 days. Some of these instruments are negotiable and actively traded, and some are not. Investors may invest directly in some of these securities, but more often they do so indirectly through money market mutual funds, which are investment companies organized to own and manage a portfolio of securities and which in turn are owned by investors. Thus, many individual investors own shares in money market funds that, in turn, own one or more of these money market certificates. Another reason of knowledge of these securities is important is the use of the Treasury bill (T-bill) as a benchmark asset. Although in some pure sense there is no such thing as a risk-free financial asset, on a practical basis the Treasury bill is risk free. There is no practical risk of default by the U.S. government. The Treasury bill rate, denoted RF, is used throughout the text as proxy for the nominal (today’s dollars) risk-free rate of return available to investors (e.g., the RF shown and discussed in Figure 1-1). In summary, money market instruments are characterized as short-term, highly marketable investments, with an extremely low probability of default. Because the minimum investment is generally large, money market securities are typically owned by individual investors indirectly in the form of investment companies known as money market mutual funds, or, as they are usually called, money market funds. Money market rates tend to move together, and most rates are very close to each other for the same maturity. Treasury bill rates are less than the rates available on other money market securities, approximately one-third of a percentage point, because of their risk-free nature. Important Money Market Securities Treasury bills. The premier money market instrument, a fully guaranteed, very liquid IOU from the U.S. Treasury. They are sold on an auction basis every week at a discount from face value in denominations of $10,000 to $1 million; therefore, the discount determines the yield. The greater the discount at time of purchase, the higher the return earned by investors. Typical maturities are 13 and 26 weeks. New bills can be purchased by investors on a competitive or noncompetitive bid basis. Outstanding (i.e., already issued) bills can be purchased and sold in the secondary market, an extremely efficient market where government securities dealers stand ready to buy and sell these securities. Negotiable certificates of deposit (CDs). Issued in exchange for a deposit of funds by most American banks, the CD is a marketable deposit liability of the issuer, who usually stands ready to sell new CDs on demand. The deposit is maintained in the bank until maturity, at which time the holder receives the deposit plus interest. However, these CDs are negotiable, meaning that they can be sold in the open market before maturity. Dealers make a market in these unmatured CDs. Maturities typically range from 14 days (the minimum maturity permitted) to one year. The minimum deposit is $100,000. Commercial paper. A short-term, unsecured promissory note issued by large, well-known, and financially strong corporations (including finance companies). Denominations start at $100,000, with a maturity of 270 days or less. Commercial paper is usually sold at a discount either directly by the issuer or indirectly through a dealer, with rates comparable to CDs. Although a secondary market exists for commercial paper, it is weak and most of it is held to maturity. Commercial paper is rates by a rating service as to quality (relative probability of default by the issuer). Eurodollars. Dollar-denominated deposits held in foreign banks or in offices of U.S. banks allocated abroad. Although this market originally developed in Europe, dollar-denominated deposits can now be made in many countries, such as those of Asia. Eurodollar deposits consist of both time deposits and CDs, with the latter constituting the largest component of the Eurodollar market. Maturities are mostly short term, often less than six months. The Eurodollar market is primarily a wholesale market, with large deposits and large loans. Major international banks transact among themselves with other participants including multinational corporations and governments. Although relatively safe, Eurodollar yields exceed those of other money market assets because of the lesser regulation for Eurodollar banks. Repurchase agreements (RPs). An agreement between a borrower and a lender (typically institutions) to sell and repurchase U.S. government securities. The borrower initiates an RP by contracting to sell securities to a lender and agreeing to repurchase these securities at a prespecified price on a stated date. The effective interest rate is given by the difference between the purchase price and the sale price. The maturity of RPs is generally very short, from three to 14 days, and sometimes overnight. The minimum denomination is typically $100,000. Banker’s acceptance. A time draft drawn on a bank by a customer, whereby the bank agrees to pay a particular amount at a specified future date. Banker’s acceptance are negotiable instruments because the holder can sell them for less than face value (i.e., discount them) in the money market. They are normally used in international trade. Banker’s acceptances are traded on a discount basis, with a minimum denomination of $100,000. Maturities typically range from 30 to 180 days, with 90 days being the most common. Try a mini-quiz on Money Market Funds Characteristics of Bonds We begin our review of the principal types of capital market securities typically owned directly by individual investors with fixed-income securities. All of these securities have a specified payment schedule. In most cases, such as with a traditional bond, the amount and date of each payment are known in advance. Some of these securities deviate from the traditional-bond format, but all fixed-income securities have a specified payment or repayment schedule - they must mature at some future date. Bonds can be described simply as long-term debt instruments representing the issuer’s contractual obligation, or IOU. The buyer of a newly issued coupon bond is lending money to the issuer who, in turn, agrees to pay interest on this loan and repay the principal at a stated maturity date. Investing in Bonds Bonds are fixed-income securities because the interest payments (if any) and the principal repayment for a typical bond are specified at the time the bond is issued and fixed for the life of the bond. At the time of purchase, the bond buyer knows the future stream of cash flows to be received from buying and holding the bond to maturity. Barring default by the issuer, these payments will be received at specified intervals until maturity, at which time the principal will be repaid. However, if the buyer decides to sell the bond before maturity, the price received will depend on the level of interest rates at that time. The par value (face value) of most bonds is $1,000, and we will use this number as the amount to be repaid at maturity. The typical bond matures (terminates) on a specified date and is technically known as a term bond. Most bonds are coupon bonds, where coupon refers to the periodic interest that the issuer pays to the holder of the bonds. Interest on bonds is typically paid semiannually. The most radical innovation is the format of traditional bonds is the zero coupon bond, which is issued with no coupons, or interest, to be paid during the life of the bond. The purchaser pays less than par value for zero coupons and receives par value at maturity. The difference in these two amounts generates an effective interest rate, or rate of return. As in the case of Treasury bills, which are sold at discount, the lower the price paid for the coupon bond, the higher the effective return. Issuers of zero coupon bonds include corporations, municipalities, government agencies, and the U.S. Treasury. In 1985 the Treasury created its STRIPS, or Separate Trading of Registered Interest and Principal of Securities. Under this program, all new Treasury bonds and notes with maturities greater than ten years are eligible to be "stripped" to create zero coupon Treasury securities that are direct obligations of the Treasury. More on zero coupon bonds Bond prices are quoted as a percentage of par value. By convention, corporates and Treasuries use 100 as par rater than 1,000. Therefore, a price of 90 represents $900, and a price of 55 represents $550 using the normal assumption of a par value of $1,000. Each "point", or a change of "1", represents 1% of $1,000 or $10. The easiest way to convert quoted bond prices to actual prices is to remember that they are quoted in percentages, with the common assumption of a $1,000 par value. The bond buyer must pay the bond seller the price of the bond as well as the interest that has been earned (accrued) on the bond since the last semiannual interest payment. This allows an investor to sell a bond any time without losing the interest that has accrued. Bond buyers should remember this additional "cost" when buying a bond because prices are quoted in the paper without the accrued interest. At any point in time some bonds are selling at premiums (prices above par value), reflecting a decline in market rates after that particular bond was sold. Others are selling at discounts (prices below par value of $1,000), because the stated coupons are less than the prevailing interest rate on a comparable new issue. The call provision gives the issuer the right to “call in” the bonds, thereby depriving investors of that particular fixed-income security. Exercising the call provision becomes attractive to the issuer when market interest rates drop sufficiently below the coupon rate on the outstanding bonds for the issuer to save money. Costs are incurred to call the bonds, such as a "call premium" and administrative expenses. However, issuers expect to sell new bonds at a lower interest cost, thereby replacing existing higher interest-cost bonds with new, lower interest-cost bonds. The call feature is a disadvantage to investors who must give up the higher yielding bonds. The wise bond investor will note the bond issue’s provisions concerning the call, carefully determining the earliest date at which the bond can be called and the bond’s yield if it is called at the earliest date possible. Some investors have purchased bonds at prices above face value and suffered a loss when the bonds were unexpectedly called in and paid off at face value. Some bonds are not callable. Most Treasury bonds cannot be called, although some older Treasury bonds can be called within five years of the maturity date. A bond has certain legal ramifications. Failure to pay either interest or principal on a bond constitutes default for that obligation. Default, unless quickly remedied by paying or a voluntary agreement with the creditor, leads to bankruptcy. A filing of bankruptcy by a corporation initiates litigation and involvement by a court, which works with all parties concerned. U.S. Government and Agency Bonds There are four major types of bonds in the United States based on the issuer involved (U.S. government, federal agency, municipal, and corporate bonds), and variations exist within each major type. U.S. Government Bonds. The U.S. government, in the course of financing its operations through the Treasury Department, issues numerous notes and bonds with maturities greater than one year. The U.S. government is considered the safest credit risk because of its power to print money; therefore, for practical purposes investors do not consider the possibility of risk of default for these securities. An investor purchases these securities with the expectation of earning a steady stream of interest payments and with full assurance of receiving the par value of the bonds when they mature. More on Government Bonds Treasury Bonds generally have maturities of 10 to 30 years, although a bond can be issued with any maturity. Like Treasury bills, they are sold at competitive auctions; unlike bills, they are sold at face value, with investors submitting bids on yields. Interest payments (coupons) are paid semiannually. Face value denominations are $1000, $5000, $10,000, $100,000, $500,000, and $1 million. Federal Credit Agencies. Since the 1920s, the federal government has created various federal agencies designed to help certain sectors of the economy, through either direct loans or guarantee of private loans. These various credit agencies compete for funds in the marketplace by selling government agency securities. There are two types of federal credit agencies: federal agencies and federally sponsored credit agencies. Legally, federal agencies are part of the federal government and their securities are fully guaranteed by the Treasury. The most important “agency” for investors is the Government National Mortgage Association (often referred to as "Ginnie Mae"). In contrast to federal agencies that are officially a part of the government, federally sponsored credit agencies are privately owned institutions that sell their own securities in the marketplace in order to raise funds for their specific purposes. Although these agencies have the right to draw on Treasury funds up to some approved amount, their securities are not guaranteed by the government as to principal or interest. Nevertheless, the rapidly growing agency market is dominated by these federally sponsored credit agencies, which include the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, the Federal Home Loan Ban,, the Farm Credit System, and the Student Loan Marketing Association. Perhaps the best known of these federally sponsored agencies is the Federal National Mortgage Association (FNMA, typically referred to as "Fannie Mae"), which is designed to help the mortgage markets. Although government sponsored, it is now a privately owned corporation, and its securities are not a direct obligation of the U.S. government. A variety of Fannie Mae issues are available, with maturities ranging from short term to long term. The Federal National Mortgage Association, the Government National Mortgage Association, and the Federal Home Loan Mortgage Corporation (Freddie Mac) issues and guarantee securities backed by conventional mortgages bought from lenders. These securities are pat of the rapidly growing market of fixed-income securities known as asset-back securities, which are discussed separately below. Federal agency securities can be though of as an alternative to U.S. Treasury securities from the investor’s standpoint. The feeling in the market-place seems to be that the Treasury would not stand by and permit a government-sponsored agency to default; however, they have to be viewed as having slightly8 greater default risk. Also, longer term issues may trade less frequently8 than comparable Treasury bonds. Together, these two factors cause these securities to carry slightly higher yields than Treasury securities of comparable maturity. Municipal Bonds Bonds sold by states, counties, cities, and other political entities (e.g., airport authorities, school districts) other than the federal government and its agencies are called municipal bonds. There are roughly 50,000 different issuers with roughly 1.5 million different issues outstanding and credit ratings ranging from very good to very suspect. Thus, risk varies widely, as does marketability. Overall, however, the default rate on municipal bonds has been quite favorably compared to corporate bonds. Two basic types of municipals are general obligation bonds, which are repaid from the revenues generated by the project they were sold to finance (e.g., a toll road or airport improvement). In the case of general obligation bonds, the issuer can tax residents to pay for the bond interest and principal. In the case of revenue bonds, the project must generate enough revenue to service the issue. Most long-term municipals are sold as serial bonds, which means that a specified number of the original issues mature each year until the final maturity date. For example, a 10-year serial issue of the municipals might have 10 percent of the issue maturing each year for the next 10 years. The distinguishing feature of most municipals is their exemption from federal taxes. Because of this feature, the stated rate on these bonds will be lower than that on comparable nonexempt bonds. The higher an investor’s tax bracket, the most attractive municipals become. To make the return on these bonds comparable to those of taxable bonds, the taxable equivalent yield (TEY) can be calculated. The TEY shows the interest rate on taxable bonds necessary to provide an after-tax return equal to that of municipals. The TEY for any municipal bond return and any marginal tax bracket can be calculated using the following formula: An investor in the 28 percent marginal tax bracket who invests in a 5 percent municipal bond would have to receive... 0.05/(1 - 0.280) = 6.94% ... from a comparable taxable bond to be as well off. More on muni's In some cases, the municipal bondholder can also escape state and/or local taxes. For example, a North Carolina resident purchasing a bond issued by the state of North Carolina would escape all taxes on the interest received. Corporate Bonds Most of the larger corporations, several thousand in total, issue corporate bonds to help finance their operations. Many of these firms have more than one issue outstanding. Although an investor can find a wide range of maturities, coupons, and special features available from corporates, the typical corporate bond matures in 20 to 40 years, pays semiannual interest, is callable, carries a sinking fund, and is sold originally at a price close to par value, which is almost always $1000. Corporate bonds are senior securities. That is, they are senior to any preferred stock and to the common stock of a corporation in terms of priority of payment and in case of bankruptcy and liquidation. However, within the bond category itself there are various degrees of security. The most common type of unsecured bond is the debenture, a bond backed only by the issuer’s overall financial soundness. Debentures can be subordinated, resulting in a claim on income that stands below (subordinate to) the claim of the other debentures. Foreign Bonds Why would one consider foreign bonds for inclusion in their portfolios? One reason is that at times foreign bonds may offer higher returns at a given point in time than alternative domestic bonds. Each country has its own economy and inflation and interest rates can vary dramatically from country to country depending upon the current stages of economic condition. A second important reason for buying foreign bonds is the diversification aspect. Diversification is extremely important, both in a stock portfolio and a bond portfolio. Bond prices in some foreign countries may be rising at the same time that U.S. bond prices are declining. Keep in mind that investors rarely receive an advantage through an investment without at least some disadvantage being present. One of the disadvantages an investor faces is the difficulty of investing directly in foreign bonds. It is relatively costly and can be time-consuming. Selling foreign bonds that are directly owned also can be a problem. Secondary markets in foreign countries are not comparable to the large bond markets in the U.S. This means that individual investors selling small amounts of foreign bonds abroad will typically incur significant price concessions. Investors who are considering direct investment in foreign bonds face the additional issue of transaction costs. Dollars must be converted into the foreign currency to make purchases, and receipts from the foreign bonds must be converted back into dollars. On small transactions, these costs can significantly impact returns. These problems can generally be overcome by investing in mutual funds that hold foreign bonds. Regardless of whether the investment is made direct or through mutual funds, investors of foreign bonds must always deal with exchange rate risk. An adverse movement in the dollar can result in an American investor’s return being lower than the return on the asset, or even negative. Convertible Bonds Convertible bonds have a built-in conversion feature. The holders of these bonds have the option to convert whenever they choose. Typically, the bonds are turned in to the corporation in exchange for a specified number of common shares, with no cash payment required. Convertible bonds are two securities simultaneously: a fixed-income security paying a specified interest payment and a claim on the common stock that will become increasingly valuable as the price of the underlying common stock rises. Thus, the prices of convertibles may fluctuate over a fairly wide range, depending on whether they currently are trading like other fixed-income securities or are trading to reflect the price of the underlying common stock. Investors should not expect to receive the conversion option free. The issuer sells convertible bonds at a lower interest rate than would otherwise to paid, resulting in a lower interest return to investors. Asset-backed Securities The money and capital markets are constantly adapting to meet new requirements and conditions. This has given rise to new types of securities that were not previously available. Securitization refers to the transformation of illiquid, risky individual loans into more liquid, less risky securities referred to as asset-backed securities (ABS). The best example of this process, the mortgage-backed securities issued by the federal agencies mentioned above, such as Ginnie Mae, are securities representing an investment in an underlying pool of mortgages. The federal agencies discussed earlier purchase mortgages from banks and thrift institutions, repackage them in the form of securities, and sell them to investors as mortgage pools. Investors in mortgage-backed securities are, in face, purchasing a piece of a mortgage pool, taking into consideration such factors as maturity and the spread between the yield on the mortgage security and the yield on 10-year Treasuries (considered a benchmark in this market). Investors in mortgage-backed securities assume little default risk because most mortgages are guaranteed by one of the government agencies. However, these securities present investors with uncertainty because they can receive varying amounts of monthly payments depending on how quickly homeowners pay off their mortgages. Although the stated maturity can be as long as 40 years, the average life of these securities to date has been much shorter. Ginnie Mae issues are well known to investors. This wholly owned government agency issues fully backed securities (i.e., they are full faith and credit obligations of the U.S. government) in support of the mortgage market. The GNMA pass-through securities have attracted considerable attention in recent years because the principal and interest payments on the underlying mortgages used to collateralize them are "passed through" to the bondholder monthly as the mortgages are repaid. As a result of the trend to securitization, other asset-backed securities have proliferated as financial institutions have rushed to securitize various types of loans. Marketable securities have been backed by car loans, credit-card receivables, railcar leases, small-business loans, photocopier leases, aircraft leases, and so forth. The assets that can be securitized seem to be limited only by the imagination of the packagers, as evidenced by the fact that by 1996 new asset types include royalty streams from films, student loans, mutual fund fees, tax liens, monthly electric utility bills, and delinquent child support payments. Who do investors like these asset-backed securities? The attractions are relatively high yields and relatively short maturities (often, five years) combined with investment-grade credit ratings, typically the highest two ratings available. Investors are often protected by a bond insurer. Institutional investors such as pension funds and life insurance companies have become increasingly attracted to ABS because of the higher yields, and foreign investors are now buying these securities more often. As for risks, securitization works best when packaged loans are homogeneous, so that income streams and risks are more predictable. This is clearly the case for home mortgages, for example, which must adhere to strict guidelines. This is not the case for some of the newer loans being considered for packaging, such as loans for boats and motorcycles; the smaller amount of information results in a larger risk from unanticipated factors. Try a mini-quiz on bonds Equity Investments Unlike fixed-income securities, equity securities represent an ownership interest in a corporation. These securities provide a residual claim - after payment of all obligations to fixed-income claims - on the income and assets of a corporation. There are two forms of equities, preferred stock and common stock. Investors are primarily interested in common stocks. Common Stock Characteristics of Common Stock. Common stock represents the ownership interest of corporations, or the equity of the stockholders, and we can use the term equity securities interchangeably. If a firm’s shares are held by only a few individuals, the firm is said to be "closely held." Most companies choose to "go public;" that is, they sell common stock to the general public. This action is taken primarily to enable the company to raise additional capital more easily. If a corporation meets certain requirements. It may, if it chooses to, be listed on one or more exchanges. Otherwise, it will be listed in the over-the-counter market. As a purchaser of 100 shares of common stock, an investor owns 100/n percent of the corporation (where n is the number of shares of common stock outstanding). As the residual claimants of the corporation, stockholders are entitled to income remaining after the fixed-income claimants (including preferred stockholders) have been paid; also, in the case of liquidation of the corporation, they are entitled to the remaining assets after all other claims (including preferred stock) are satisfied. As owners, the holders of common stock are entitled to elect the directors of the corporation and vote on major issues. Each owner is usually allowed to cast votes equal to the number of shares owned for each director being elected. Such votes occur at the annual meeting of the corporation, which each shareholder is allowed to attend. Most stockholders vote by proxy meaning that the stockholder authorizes someone else (typically management) to vote his or her shares. Sometimes proxy battles occur, whereby one or more groups unhappy with corporate policies seek to bring about changes. The Public Register's Annual Report Service Stockholders also have limited liability, meaning that they cannot lose more than their investment in the corporation. In the event of financial difficulties, creditors have recourse only to the assets of the corporation, leaving the stockholders protected. This is perhaps the greatest advantage of the corporation and the reason why it has been so successful. The par value (stated or face value) for a common stock, unlike a bond or preferred stock, is generally not a significant economic variable. Corporations can make the par value any number they choose. Some corporations issue no-par stock. New stock is usually sold for more than par value, with the difference recorded on the balance sheet as "capital in excess of par value." The book value of a corporation is the accounting value of the equity as shown on the books (i.e., balance sheet). It is the sum of common stock outstanding, capital in excess of par value, and retained earnings. Dividing this sum, or total book value, by the number of common shares outstanding produces the book value per share. In effect, book value is the accounting value of the stockholders’ equity. Although book value per share plays a role in making investment decisions, market value per share is the critical item of interest to investors. The market value (i.e., price) of the equity is the variable of concern to investors. The aggregate market value for a corporation, calculated by multiplying the market price per share of the stock by the number of shares outstanding, represents the total value of the firm as determined in the marketplace. The market value of one share of stock, of course, is simply the observed current market price. Dividends are the only cash payments regularly made by corporations to their stockholders. They are decided upon the declared by the board of directors and can range from zero to virtually any amount the corporation can afford to pay (typically, up to 100 percent of present and past net earnings). Although roughly three-fourths of the companies listed on the NYSE pay dividends, the common stockholder has no specific promises to receive any cash from the corporation since the stock never matures, and dividends to not have to be paid. Therefore, common stocks involve substantial risk because the dividend is at the company’s discretion and stock prices typically fluctuate sharply, which means that the value of investors’ claims may rise and fall rapidly over relatively short periods of time. The following two dividend terms are important: The dividend yield is the income component of a stock’s return stated on a percentage basis. It is one of the two components of total return. Dividend yield typically is calculated as the most recent 12-month dividend divided by the current market price. The payout ratio is the ratio of dividends to earnings. It indicates the percentage of a firm’s earnings paid out in cash to its stockholders. The complement of the payout ratio, or (1.0 – payout ratio), is the retention ratio, and it indicates the percentage of a firm’s current earnings retained by it for reinvestment purposes. Dividends are declared and paid quarterly. To receive a declared divided, an investor must be a holder of record on the specified date that a company closes its stock transfer books and compiles the list of stockholders to be paid. However, to avoid problems, the brokerage industry has established a procedure of declaring that the right to the dividend remains with the stock until four days before the holder-of-record date. On this fourth day, the right to the dividend leaves the stock; for that reason this date is called the ex-dividend date. Stock dividends and stock splits attract considerable investor attention. A stock dividend is a payment by the corporation in shares of stock instead of cash. A stock split involves the issuance of a larger number of shares in proportion to the existing shares outstanding. With a stock split, the book value and par value of the equity are changed; for example, each would be cut in half with a 2-for-1 split. However, on a practical basis, there is little difference between a stock dividend and a stock split. Example. A 5 percent stock dividend would entitle an owner of 100 shares of a particular stock to an additional five shares. A 2-for-1 stock split would double the number of shares of the stock outstanding, double an individual owner’s number of shares (e.g., from 100 shares to 200 shares), and cut the price in half at the time of the split. Stock data, as reported to investors in most investment information sources and in the company’s reports to stockholders, typically are adjusted for all stock dividends and stock splits. Obviously, such adjustments must be made when stock splits or stock dividends occur in order for legitimate comparisons to be made for the data. The important question to investors is the value of the distribution, whether a dividend or a split. It is clear that the recipient has more shares (i.e., more pieces of paper), but has anything of real value been received? Other things being equal, these additional shares do not represent additional value because proportional ownership has not changes. Quite simply, the pieces of paper, stock certificates, have been repackaged. For example, if you own 1000 shares of a corporation that has 100,000 shares of stock outstanding, your proportional ownership is 1 percent; with a 2-for-1 split, your proportional ownership is still 1 percent, because you now own 2000 shares out of a total of 200,000 shares outstanding. If you were to sell y our newly distributed shares, however, your proportional ownership would be cut in half. Capitalization Stocks are sometimes categorized by their size. Market capitalization refers to a company’s size and is derived by multiplying the number of shares outstanding by the current market price of the shares. This is a very important concept. Stock A may be trading at $22 per share and stock B trading at $20 per share. One cannot assume that company A is therefore “worth more” than company B. Company A may have one million shares outstanding and company B could have eight million shares outstanding, making the total value of all it’s stock (market capitalization) much greater than that of company A. Generally, stocks are considered to fall into one of the following three categories: Small Cap(italization) – Stocks with a market capitalization of less than $750 million. Historically these have been among the best and worst performers within the stock market because they are usually younger, less established companies. They obviously carry more investment risk because of that. Mid Cap - Stocks with market capitalization of from $750 million to $3 or $4 billion. While the standard deviation (risk measurement) is higher for these stocks than the large caps, it is considerably less than small caps. Over one thousand companies fit this category and some are household names. Large Cap - Stocks with market capitalization over $4 billion. Many of these companies are among the largest in their respective field and are household names. This category of stocks tends to be the most widely covered by research analysts and institutions. Click here for a discussion of large cap stocks. Industry or Sector Stocks are usually categorized according to the industry group within which they operate; for example, food and beverage stocks, telecommunications stocks, consumer non-durable stocks, energy stocks, and so on. By grouping companies this way it makes for a clearer comparison and analysis of companies management, products, balance sheets, operating histories, etc. In addition to being able to purchase shares of stock of companies in a preferred sector, one can purchase groups of representative stocks from a sector. These "groups of stocks" are similar to indexes and trade on a listed exchange much like an individual stock. More on sector-based equity portfolios Additionally, one can purchase mutual funds that invest only in stated industries or sectors. This offers an individual the potential to prosper from growth in the group with the element of diversification without the burden of selecting "the stock" one thinks will best perform. Domestic and Foreign In addition to investing in U.S. stocks, opportunities exist in the stocks of companies throughout the world. In fact, many companies may be headquartered in one country but with the majority of its revenues derived from foreign operations. For example, a majority of the sales of Coca Cola Company come from outside the United States. With more and more companies taking on a multi-national status, the distinction between domestic and foreign may not be as clear as it once was. However, one should note that there are some additional risk factors associated with foreign stock ownership including regulatory differences, accounting practices, currency fluctuations, and political unrest. There are many mutual funds available that offer foreign investments. Be aware that the term "international fund" usually means the fund invests only in stocks outside the U.S, whereas "global fund" means U.S. stocks may be included in the portfolio. Foreign firms can also arrange to have their shares traded on an exchange or a market in another country. In the United States, two alternatives are available for trading internationally listed foreign securities. One is for the shares to be traded directly. The second alternative is via American Depository Receipts (ADRs), which have existed since 1927. ADRs represent indirect ownership of a specified number of shares of a foreign company. These shares are held on deposit in a bank in the issuing company’s home country, and the ADRs are issued by U.S. banks called depositories. The prices or ADRs are quoted in dollars, and dividends are paid in dollars. In effect, ADRs are tradable receipts issued by depositories that have physical possession of the foreign securities through their foreign correspondent banks or custodian. Holders can choose to convert their ADRs into the specified number of foreign share represented by paying a fee, although this is rarely done. ADRs can be an effective way for an American investor to invest in specific foreign stocks without having to worry about currency problems. More on ADRs Initial and Secondary Offerings As companies grow and need to access capital to fuel that growth, they sometimes determine to "go public" by selling some of their privately held shares in the company to the public. This results in an initial offering, also known as an IPO. In the course of selling new securities, issuers often rely on an investment banker for the necessary expertise as well as the ability to reach widely dispersed suppliers of capital. Along with performing activities such as helping corporations in mergers and acquisitions, investment banking firms specialize in the design and sale of securities in the primary market while operating simultaneously in the secondary markets. Investment bankers act as intermediaries between issuers and investors. The issuer sells its securities to investment bankers, who in turn sell the securities to investors. For firms seeking to raise long-term funds, the investment banker can provide important advice to their clients during the planning stage preceding the issuance of new securities. This advice includes providing information about the type of security to be sold, the features to be offered with the security, the price, and the timing of the sale. Investment bankers often underwrite new issues by purchasing the securities and assuming the risk of reselling them to investors. Investment bankers are compensated by a spread, which is the difference between what they pay the issuer for the securities and what they sell them for to the public. Often investment bankers will protect themselves by forming a syndicate, or group of investment bankers to share the risk of not being able to successfully resell the securities to the public. Their can be a selling group which includes syndicate members and, if necessary, other firms affiliated with the syndicate. The IPO may not be the only time the company needs to raise significant amounts of new funds through an equity offering. Subsequent offerings are termed secondary offerings. One of the main differences with a secondary offering is that the pricing of the security is much easier to determine since the stock has already been actively trading in the marketplace. Click here for a discussion of secondary offerings. Preferred stock Although technically an equity security, preferred stock is known as a hybrid security because it resembles both equity and fixed-income instruments. As an equity security, preferred stock has an infinite life and pays dividends. Preferred stock resembles fixed-income securities in that the dividend is fixed in amount and known in advance, providing a stream of income very similar to that of a bond. The difference is that the stream continues forever, unless the issue is called or otherwise retired (most preferred is callable). The price fluctuations in preferreds often exceed those in bonds. Preferred stockholders are paid after the bondholders but before the common stockholders in terms of priority of payment of income and in case the corporation is liquidated. However, preferred stock dividends are not legally binding but must be voted on each period by a corporation’s board of directors. If the issuer fails to pay the dividend in any year, the unpaid dividend(s) will have to be paid in the future before common stock dividends can be paid if the issue is cumulative. (If non-cumulative, dividends in arrears do not have to be paid.) More than one-third of the preferred stock sold in recent years is convertible into common stock at the owner’s option. A large amount of the total outstanding is variable-rate preferred; that is, the dividend rate is tied to current market interest rates. New trends in preferred stocks include auction-rate preferred, a type of floating-rate preferred where the dividend is established by auction every 49 days. A new trend in this area is a hybrid security combining features of preferred stock and corporate bonds. These hybrid securities are available from brokerage houses under various acronyms, such as MIPs and QUIPS (monthly income preferred securities and quarterly income preferred securities). For individual investors, these securities are an alternative to corporate bonds and traditional preferred stocks. Most are traded on the NYDE, offer fixed monthly or quarterly dividends considerably higher than investment-grade corporate bond yields, are rated as to credit risk, and have maturities in the 30-49 year range. Hybrids are sensitive to interest rate changes and can be called, although a fixed dividend is paid for five years. Private Placements In recent years an increasing number of corporations have executed private placements, whereby new securities issues (typically, debt securities) are sold directly to financial institutions, such as life insurance companies and pension funds, bypassing the open market. One advantage is that the firm does not have to register the issue with the SEC, thereby saving both time and money. Investment bankers’ fees also are saved because they are not typically used in private placements, and even if they are used, the underwriting spread is saved. The disadvantages of private placements include a higher interest cost, because the financial institutions usually charge more than would be offered in a public subscription, and possible restrictive provisions on the borrower’s activities. Private placements are also accomplished all over the country by business people who are raising capital for any number of small businesses or ventures. These placements limit the number of investors (usually thirty-five) and investors must be deemed to be accredited, meaning they must meet certain income and/or net worth qualifications. Derivatives Options There are two types of derivative securities that are of interest to most investors. Options and futures contracts are derivative securities, so named because their value is derived from their connected underlying security. Numerous types of options and futures are traded in world markets. Furthermore, there are different types of options other than the puts and cans discussed here. For example, a warrant is a corporate-created, long-term option on the underlying common stock of the company. It gives the holder the right to buy the stock from the company at a stated price within a stated period of time, typically several years. Options and futures contracts share some common characteristics. Both have standardized features that allow them to be traded quickly and cheaply on organized exchanges. In addition to facilitating the trading of these securities, the exchange guarantees the performance of these contracts and its clearinghouse allows an investor to reverse his or her original position before maturity. For example, a seller of a futures contract can buy the contract and cancel the obligation that the contract carries. The exchanges and associated clearinghouses for both options and futures contracts have worked extremely well. Options and futures contracts are important to investors because they provide a way for investors to manage portfolio risk. For example, investors may incur the risk of adverse currency fluctuations if they invest in foreign securities, or they may incur the risk that interest rates will adversely affect their fixed-income securities. Options and futures contracts can be used to limit some, or all, of these risks, thereby providing risk-control possibilities. Options and futures contracts have important differences in their trading, the assets they can affect, their risk factor, and so forth. Perhaps the biggest difference to note now is that a futures contract is an obligation to buy or sell, but an options contract is only the right to do so, as opposed to an obligation. The buyer of an option has limited liability, but the buyer of a futures contract does not. OPTIONS In today's investing world, the word options refers to puts and calls. Options are created not by corporations but by investors seeking to trade in claims on a particular common stock. A call (put) option gives the buyer the right to purchase (sell) 100 shares of a particular stock at a specified price (called the exercise price) within a specified time. The maturities on most new puts and calls are available up to several months away, although a new form of puts and calls called LEAPs has maturity dates up to a couple of years. Several exercise prices are created for each underlying common stock, giving investors a choice in both the maturity and the price they will pay or receive. Buyers of calls are betting that the price of the underlying common stock will rise, making the call option more valuable. Put buyers are betting that the price of the underlying common stock will decline, making the put option more valuable. Both put and call options are written (created) by other investors who are betting the opposite of their respective purchasers. The sellers (writers) receive an option premium for selling each new contract while the buyer pays this option premium. Once the option is created and the writer receives the premium from the buyer, it can be traded repeatedly in the secondary market. The premium is simply the market price of the contract as determined by investors. The price will fluctuate constantly, just as the price of the underlying common stock changes. This makes sense, because the option is affected directly by the price of the stock that gives it value. In addition, the option's value is affected by the time remaining to maturity, current interest rates, the volatility of the stock, and the price at which the option can be exercised. Puts and calls allow both buyers and sellers (writers) to speculate on the short- term movements of certain common stocks. Buyers obtain an option on the common stock for a small, known premium, which is the maximum that the buyer can lose. If the buyer is correct about the price movements on the common, gains are magnified in relation to having bought (or sold short) the common because a smaller investment is required. However, the buyer has only a short time in which to be correct. Writers (sellers) earn the premium as income, based on their beliefs about a stock. They win or lose, depending on whether their beliefs are correct or incorrect. Options can be used in a variety of strategies, giving investors opportunities to manage their portfolios in ways that would be unavailable in the absence of such instruments. For example, since the most a buyer of a put or call can lose is the cost of the option, the buyer is able to truncate the distribution of potential returns. That is, after a certain point, no matter how much the underlying stock price changes, the buyer's position does not change. Futures Futures contracts have been available on commodities such as corn and wheat for a long time. Recently, they have also become available on several financial instruments, including stock market indexes, currencies, Treasury bins, Treasury bonds, bank certificates of deposit, and GNMAS. A futures contract is an agreement that provides for the future exchange of a particular asset between a buyer and a seller. The seller contracts to deliver the asset at a specified delivery date in exchange for a specified amount of cash from the buyer. Although the cash is not required until the delivery date, a "good faith deposit," called the margin, is required to reduce the chance of default by either party. The margin is small compared to the value of the contract. Most futures contracts are not exercised. Instead, they are "offset" by taking a position opposite to the one initially undertaken. For example, a purchaser of a May Treasury bill futures contract can close out the position by selling an identical May contract before the delivery date, while a seller can close out the same position by purchasing that contract. Most participants in futures are either hedgers or speculators. Hedgers seek to reduce price uncertainty over some future period. For example, by purchasing a futures contract, a hedger can lock in a specific price for the asset and be protected from adverse price movements. Similarly, sellers can protect themselves from downward price movements. Speculators, on the other hand, seek to profit from the uncertainty that will occur in the future. If prices are expected to rise (fall), contracts will be purchased (sold). Correct anticipations can result in very large profits because only a small margin is required. One of the newest innovations in financial markets is options on futures. Calls on futures give the buyer the right, but not the obligation, to assume the futures position. Real Estate. Real estate has historically been useful in a portfolio for both income and capital gains. Home ownership, in itself, is a form of equity investment, as is the ownership of a second or vacation home, since these properties generally appreciate in value. Other types of real estate, such as residential and commercial rental property, can create income streams as well as potential long-term capital gains. Real Estate investments can be made directly, with a purchase in your own name or though investments in limited partnerships, mutual funds, or Real Estate Investment Trusts (REIT). REIT is a company organized to invest in real estate. Shares are generally traded in the organized exchanges. Also, there are many kinds of real estate investments. Some are very speculative while others are more conservative. The major classifications are: Unimproved land Improved Real Estate New and used residential property Vacation homes Low income housing Certified historic rehab structures Other income-producing real estate such as office buildings, shopping centers and industrial or commercial properties Mortgages such as through certificates packaged and sold through entities such as FNMA (Federal National Mortgage Assn.) and GNMA (Government National Mortgage Assn.) Advantages The potential for high return in real estate exists due, in part to the frequent use of financial leverage. Financial leverage is the use of borrowed funds, as in a long-term mortgage, to try to increase the rate of return that can be earned on the investment. When the cost of borrowing is less than what can be earned on the investment, it is considered "favorable" leverage, but when the reverse is true, it is considered "unfavorable" leverage. There are potential tax advantages in real estate, as well. First, for personal use residential property, there is the opportunity to deduct interest paid (first and second homes, within limitations) There may also be a deductions for property taxes. If the property is income-producing, other expenses may be deductible, as well, such as depreciation, insurance, and repairs. Also real estate can be traded or exchanged for like-kind property on a tax-free basis. And, lastly, if the sale of investment real estate results in a profit, the gain is normally a capital gain. (Note: Real estate investment was dealt a blow under the Tax Reform Act of 1986, and the related rules are somewhat complex, as it relates to passive business activities, so your tax adviser should be consulted concerning any tax implications for your specific situation.) Some consider real estate a good hedge against inflation. Good quality carefully-selected income property will generally produce a positive cash flow. As a real estate owner, you may be in a position to take your gains from real estate through refinancing the property without having to sell the property, therein triggering a taxable capital gain. Real estate is advantageous, in this respect because good quality properties can be used to secure mortgage loans up to a relatively high percentage of current value. Disadvantages There is generally limited marketability in real estate (depending on the nature and location of the property.) There is also a lack of liquidity, in that there is no guarantee that the property can be disposed of at its original value, especially if it must be done within short period of time. A relatively large initial investment often is required to buy real estate. If ownership in investment property is held directly by the investor, there are many "hands-on" management duties that must be performed. Real estate is often considered high risk because if is fixed in location and character. It is particularly vulnerable to economic fluctuations such as interest rate changes and/or recession. The Tax Reform Act of 1986 eliminated many of the previously-available tax advantages relating to real estate. Tangibles, precious metals, collectibles, etc. Another category of "real assets," as opposed to financial assets, available for one to invest assets, are tangible investments. Precious metals, such as gold, silver, platinum, etc. offer an investment more closely associated with financial assets, such as stocks and bonds. There is a rather large, liquid market for precious metals. While the actual metal itself can be held, there are significant practical problems and expenses associated with that and thus this method of ownership has become rather unpopular. More commonly, minted coins would be held. Investment exposure is commonly achieved through the purchase of mining stocks or sector mutual funds that specialize in the natural resource area. Collectibles can include anything from paintings, to stamps, to automobiles, to Barbie dolls. There is virtually no end to what people collect with the anticipation that the price for these items will rise in the future, primarily because of a perceived future rarity of the item. While there have been cases of windfall profits, be aware that there are a couple of inherent problems with these investments. First of all, they rarely if ever pay the investor an ongoing income stream such as the interest from a bond or the dividends from a stock; therefore, the investment can be "dead money" while being held. Secondly, there often is a very limited market for resale of the items, resulting in both poor liquidity and marketability. Insurance-based Investments and Investment Companies Annuities Characteristics of Annuities. Annuities are specifically designed to address one of the biggest concerns of today's investors - the possibility that you or your spouse could outlive your long-term savings. This may be an even more significant concern to women, who statistically are more likely to outlive their spouses. An annuity is a contract generally issued by an insurance company. Deferred annuities enable you to set aside money and have it grow on a tax-deferred basis for your future use. When you are ready to retire, you can withdraw money as needed, or you can turn the value of your annuity into a regular income stream that is guaranteed by the issuing insurance company to last the rest of your life, regardless of how long you live. The period during which your purchases to a deferred annuity grow on a tax-deferred basis is generally referred to as the accumulation phase. The period during which you receive a regular income stream - after you annuitize your contract - is the payout (or income) phase. At this point, you will begin to receive income payments comprised of the principal you've paid in, plus any earnings you have accumulated over the years. As you receive payments, you pay income tax on the portion of each payment that represents accumulated earnings, because these earnings have not yet been taxed. Most people annuitize in their retirement years, when they are likely to be in a lower tax bracket. Fixed Annuities There are various types of annuities, which differ mainly according to how the money you pay into the annuity is allocated and when income payments begin. When you purchase a deferred annuity, you can choose how you want your money to be allocated. Regardless of the option you choose, any earnings accumulate on a tax-deferred basis. A fixed deferred annuity enables you to lock in a preset rate of interest for an initial period, normally between one and three years. When the period ends, the insurance company designates a new rate of interest for the succeeding period. Under a fixed annuity, the insurance company guarantees the rate of interest for the initial period and also guarantees the return of the amount of principal you paid into your annuity. Make sure to take a look at the rate history to see what the renewal rates have been in the past. The security of your principal and earnings depends on the health of the issuing insurance company. It is the strength of the insurance company that stands behind the earnings rate guarantee. However, since fixed-annuity assets are invested in the insurance company's general account, they are subject to the claims of its creditors. That is whv it is essential to do your homework by asking if the insurer is rated high for its claims- paying ability by respected sources such as A.M. Best Company and Standard & Poors. Variable annuities offer a number of important advantages over fixed annuities: The ability to place your money in a family of professionally managed investment options - These can range from conservative money market investment options to more aggressive stock-based options. Some variable annuities may even offer an asset allocation option that provides in one portfolio strategic diversification among stocks, bonds, and money market instruments. The privilege to make tax-free transfers among portfolios - In the event that your financial situation or market conditions change, you can move assets from one portfolio to another without having to worry about paying taxes on any capital gains or income earned. The potential for higher returns and better protection against inflation over the long term than is offered by a fixed annuity- You should also be aware that because there is no guaranteed minimum rate, the value of your variable annuity could decrease, and your return will fluctuate just as the value of your underlying mutual fund investment will. Deferred annuities can be a valuable way to save for a variety of long-term goals. Any earnings from your annuity grow on a tax-deferred basis, offering two advantages. First, your money can grow faster than it can in a taxable investment with a similar rate of return, because earnings that would have been lost to taxes remain in your annuity to generate additional earnings. Second, if you wait until retirement to receive your annuity income, you may be in a lower tax bracket, adding to the value of the income you receive. Keep in mind that annuities are designed as long-term savings vehicles. If you withdraw your earnings from the annuity prior to age 59 ½ (other than in the form of lifetime income), the IRS will generally impose a 10% early withdrawal penalty and your earnings will be taxed at your current tax rate. Try a mini-quiz on Annuitiies Investment Company Characteristics An investment company such as a mutual fund is a clear alternative for an investor seeking to own stocks and bonds. Rather than purchase securities and manage a portfolio, investors can, in effect, indirectly invest by turning their money over to an investment company and allowing it to do all the work and make all the decisions (for a fee, of course). Indirect investing refers to the buying and selling of the shares of investment companies that, in turn, hold portfolios of securities. Investors who purchase shares of a particular portfolio managed by an investment company are purchasing an ownership interest in that portfolio of securities and are entitled to a pro rata share of the dividends, interest, and capital gains generated. Shareholders must also pay a pro rata share of the company's expenses and its management fee, which will be deducted from the portfolio's earnings as it flows back to the shareholders. The essential difference with indirect investing is that the investment company stands between the investors and the portfolio of securities. Although technical qualifications exist, the point about indirect investing is that investors gain and lose through the investment company's activities in the same manner that they would gain and lose from holding a portfolio directly. The differences are the costs (any sales charges plus the management fee) and the additional services gained from the investment company, such as record keeping and check-writing privileges. The decision of whether to invest directly or indirectly is an important one that all investors should think about carefully. Because each alternative has possible advantages and disadvantages, it is not necessarily easy to choose one over the other. Investors can be active investors, investing directly, or passive investors, investing indirectly. Of course, they can do both at the same time, and many individuals do exactly that. An investment company is a financial service organization that sells shares in itself to the public and uses the funds it raises to invest in a portfolio of securities such as money market instruments or stocks and bonds. By pooling the funds of thousands of investors, a widely diversified portfolio of financial assets can be purchased and the investment company can offer its owners (shareholders) a variety of services. A regulated investment company can elect to pay no federal taxes on any distribution of dividends, interest, and realized capital gains to its shareholders. The investment company acts as a conduit, "flowing through" these distributions to stockholders who pay their own marginal tax rates on them. In effect, fund shareholders are treated as if they held the securities in the fund's portfolio. After all, investment companies are pure intermediaries, and thus shareholders should pay the same taxes they would pay if they owned the shares directly.' Fund taxation is unique, with income taxed only once when it is received by its shareholders. A fund's short-term gains and other earnings are taxed to shareholders as ordinary income, while its long-term capital gains are taxed to shareholders as long-term capital gains. Tax-exempt income received by a fund is generally tax exempt to the shareholder. Investment companies are required by the Investment Company Act of 1940 to register with the Securities and Exchange Commission (SEC).' This detailed regulatory statute contains numerous provisions designed to protect shareholders. Both federal and state laws require appropriate disclosures to investors. It is important to note that investment companies are not insured or guaranteed by any government agency, or by any financial institution from which an investor may obtain shares. These are risky investments, losses can and do occur, and essentially all investment companies' promotional materials state this clearly. Click here for Mutual Fund News All investment companies begin by selling shares in themselves to the public. Most investment companies are managed companies, offering professional management of the portfolio as one of the benefits. One less well-known type of investment company is unmanaged. Unit Investment Trusts An alternative form of investment company that deviates from the normal managed type is the unit investment trust, which typically is an unmanaged, fixed- income security portfolio put together by a sponsor and handled by an independent trustee. Redeemable trust certificates representing claims against the assets of the trust are sold to investors at net asset value plus a small commission. All interest (or dividends) and principal repayments are distributed to the holders of the certificates. Most unit investment trusts hold tax-exempt securities.' The assets are almost always kept unchanged and the trust ceases to exist when the bonds mature, although it is possible to redeem units of the trust. In general, unit investment trusts are passive investments. They are designed to be bought and held, with capital preservation as a major objective. They enable investors to gain diversification, provide professional management that takes care of all the details, permit the purchase of securities by the trust at a cheaper price than if purchased individually, and ensure minimum operating costs. If conditions change, however, investors lose the ability to make rapid, inexpensive, or costless changes in their postitions. Open- and Closed-End Investment Companies Closed End. One of the two types of managed investment companies, the closed-end investment company usually sells no additional shares of its own stock after the initial public offering. Therefore, their capitalizations are fixed unless a new public offering is made. The shares of a closed-end fund trade in the secondary markets (e.g.- on the exchanges) exactly like any other stock." To buy and sell, investors use their brokers, paying (receiving) the current price at which the shares are trading plus (less) brokerage commissions. Because shares of closed-end funds trade on stock exchanges, their prices are determined by the forces of supply and demand. Interestingly, however, the market price is seldom equal to the actual per-share value of the closed-end shares. Closed-end funds have been around for a long time; in fact, they were a popular investment before the great crash of 1929. After the crash, they lost favor and were relatively unimportant until they started to attract significant investor interest again following the crash of 1987. More on closed-end funds Open-End Investment Companies (Mutual Funds) Open-end investment companies, the most familiar type of managed company, are popularly referred to as mutual funds and continue to sell shares to investors after the initial sale of shares that starts the fund. The capitalization of an open-end investment company is continually changing-that is, it is open-ended-as new investors buy additional shares and some existing shareholders cash in by selling their shares back to the company. Mutual funds typically are purchased in either of two ways: Directly, from a fund company, using mail, telephone, or at office locations. Indirectly, from a sales agent, including securities firms, banks, life insurance companies, and financial planners. Mutual funds may be affiliated with an "underwriter," which usually has an exclusive right to distribute shares to investors. Most underwriters distribute shares through broker/dealer firms. Mutual funds are corporations typically formed by an investment advisory firm that selects the board of trustees (directors) for the company. The trustees, in turn, hire a separate management company, normally the investment advisory firm, to manage the fund. The management company is contracted by the investment company to perform necessary research and to manage the portfolio, as well as to handle the administrative chores, for which it receives a fee. Given the economies of scale in managing portfolios, expenses rise as assets under management increase, but not at the same rate as revenues. Because investment managers can oversee various amounts of money with few additional costs, management companies seek to increase the size of the fund(s) being managed. Many operate several different funds simultaneously. Investors can now choose from more than 400 mutual fund complexes (a fund complex is a group of funds under substantially common management). Mutual funds are the most popular form of investment company for the typical investor. One reason is that the minimum investment requirements for most funds are small. Two-thirds of all funds require $1000 or less to get started, and 85 percent require $5,000 or less. For IRA and other retirement accounts, the minimum required is often lower. More on mutual froms from the SEC Owners of fund shares can sell them back to the company (redeem them) any time they choose; the mutual fund is legally obligated to redeem them. Investors purchase new shares and redeem their existing shares at the net asset value (NAV), which for any investment company share is computed daily by calculating the total market value of the securities in the portfolio, subtracting any trade payables, and dividing by the number of investment company fund shares currently outstanding. There are two major types of mutual funds: Money market mutual funds (short-term funds) Equity and bond & income funds (long-term funds) Money market funds concentrate on short-term investing by holding portfolios of money market assets, whereas equity and bond & income funds concentrate on longer term investing by holding mostly capital market assets, such as stocks and bonds. A major innovation in the investment company industry has been the creation, and subsequent phenomenal growth, of money market funds, which are open-end investment companies whose portfolios consist of money market instruments. Created in 1974, when interest rates were at record-high levels, money market funds grew tremendously in 1981-1982 when short-term interest rates were again at record levels and investors seeking to earn these high short-term rates found that they generally could not do so directly because of the large denominations of money market securities. However, this situation has changed with the deregulation of the thrift institutions, and competition has increased dramatically for investors' short-term savings. Banks can now offer money market deposit accounts that pay competitive money market rates and are insured. Money market funds can be divided into taxable funds and tax-exempt funds. More on Money Markets Investors in higher tax brackets should carefully compare the taxable equivalent yield on tax-exempt money market funds with that available on taxable funds because the tax-free funds often provide an edge. Taxable money market funds hold assets such as Treasury bills, negotiable CDs, and prime commercial paper. Some funds hold only bills, whereas others hold various mixtures. Commercial paper typically accounts for 40 to 50 percent of the total assets held by these funds, with Treasury bills, government agency securities, domestic and foreign bank obligations, and repurchase agreements rounding out the portfolios. The average maturity of money market portfolios ranges from approximately one month to two months. SEC regulations limit the maximum average maturity of money funds to 90 days. Tax-exempt money market funds consist of national funds which invest in short- term municipal securities of various issuers and state tax-exempt money market funds, which invest only in the issues of a single state, thereby providing additional tax benefits. Investors in money market funds pay neither a sales charge nor a redemption charge, but they do pay a management fee. Interest is earned and credited daily. The shares can be redeemed at any time by phone or wire. Many funds offer check-writing privileges for checks of $500 or more, with the investor earning interest until the check clears." Money market funds provide investors with a chance to earn the going rates in the money market while enjoying broad diversification and great liquidity. The rates have varied as market conditions changed. The important point is that their yields corresponded to current market conditions. Although investors may assume little risk because of the diversification and quality of these instruments, money market funds are not insured. Banks and thrift institutions have emphasized this point in competing with money market funds for the savings of investors. The board of directors (trustees) of an investment company must specify the objective that the company will pursue in its investment policy. The companies try to follow a consistent investment policy, according to their specified objective. Investors should purchase mutual funds on the basis of their objectives Following is a listing of most major types of mutual funds: Aggressive Growth Funds seek maximum capital appreciation (a rise in share price); current income is not a significant factor. Some funds in this category may invest in out-of-the-mainstream stocks, such as those of fledgling or struggling companies, or those in new or temporarily out-of-favor industries. Some of these funds may also use specialized investment techniques such as option writing or short-term trading For these reasons, these funds usually entail greater risk than the overall mutual fund universe. Balanced Funds generally try to balance three different objectives: moderate long-term growth of capital, moderate income, and moderate stability in an investor's principal. To reach these goals, balanced funds in- vest in a mixture of stocks and bonds. Corporate Bond Funds seek a high level of income by purchasing primarily bonds of U.S.-based corporations; they may also invest in other fixed-income securities such as U.S. Treasury bonds. Flexible Portfolio Funds may invest in any one investment class (stocks, bonds, or money market instruments) or any combination thereof, depending on the conditions in each market. Because they do not limit a fund manager's exposure to any one market, these funds provide the greatest flexibility in anticipating or responding to economic changes. Ginnie Mae or GNMA Funds seek a high level of in-come by investing primarily in mortgage securities backed by the Government National Mortgage Association. Global Bond Funds seek a high level of income by investing in the debt securities of companies and countries 1 worldwide, including issuers in the United States. The funds' money managers deal with varied currencies, languages, time zones, laws, and regulations, and business customs and practices. Because of these factors, although global funds provide added diversification, they are also subject to more risk than domestic (U.S.) bond funds. Global Equity Funds seek capital appreciation (a rise in share price) bv investing in securities traded worldwide, including issuers in the United States. These funds operate just like other global and international funds (see above), providing, added diversification but also added risk. Growth and Income Funds invest mainly in the common stock of companies that offer potentially increasing value as well as consistent dividend payments. Such funds attempt to provide investors with long term capital growth and a steady stream of income. Growth Funds invest in the common stock of companies that offer potentially rising share prices. These funds primarily aim to provide capital appreciation (a rise in share price) rather than steady income. High-yield Bond Funds maintain at least two-thirds of their portfolios in non investment-grade corporate bonds (those rated Baa or lower by Moody's rating service and BBB or lower by Standard and Poor's rating service). In return for potentially greater income, high-yield funds present investors with greater credit risk than do higher-rated bond funds. Income-Bond Funds seek a high level of income by investing in a mixture of corporate and government bonds. Income-Equity Funds seek a high level of income bv investing primarily in stocks of companies with a consistent history of dividend payments. Income-Mixed Funds seek a high level of current income by investing in income-producing securities, including both equities and debt instruments. International Funds seek capital appreciation (a rise in share price) by investing in equity securities of companies located outside the United States. Two-thirds of fund assets must be so invested at all times to qualify for this category. National Municipal Bond Funds-Long-term invest primarily in bonds issued by states and municipalities to finance schools, highways, hospitals, airports, bridges, water and sewer works, and other public projects. In most cases, income earned on these securities is not taxed by the federal government, and may or may not be taxed by state and local governments. For some taxpayers, a portion of income may be subject to the federal alternative minimum tax. Precious Metals/Gold Funds seek capital appreciation (a rise in share price) by investing at least two-thirds .of fund assets in securities associated with gold, silver, and other precious metals. State Municipal Bond Funds-Long-term work just like national municipal bond funds (see above) except that their portfolios primarily contain the issues of one state. For residents of that state, the income from these securities is typically free from both federal and state taxes. For some taxpayers, a portion of income may be subject to the federal alternative minimum tax. Taxable Money Market Mutual Funds seek the highest income consistent with preserving investment principal. These funds seek to maintain a stable $1.00 share price by investing in short-term money market securities (a portfolio's average maturity must be 90 days or less) of the highest credit quality. Examples of money market securities include U.S. Treasury bills, commercial paper (short-term IOUs) of corporations, and large-denomination certificates of deposit (CDs) of banks. Because of their short-term, high-quality characteristics, money market funds are considered the lower risk mutual funds available. Tax-exempt Money Market Funds-National seek the highest level of federally tax-free income consistent with preserving investment principal. These funds invest in short-term municipal securities issued by states and municipalities to finance local projects. For some taxpayers, a portion of income may be subject to the federal alternative minimum tax. Tax-exempt Money Market Funds-State work just like other tax-exempt money market funds (see above) except that their portfolios invest primarily in issues from one state. A resident in that state typically receives income exempt from federal and state taxes. For some taxpayers, a portion of income may be subject to the federal alternative minimum tax. U.S. Government Income Funds seek income by investing in a variety of U.S. Government securities, including Treasury bonds, federally guaranteed mortgage-backed securities, and other government- backed issues. Try a mini-quiz on Mutual Funds Valuation Methods Bond Rating Services Corporate bonds, unlike Treasury securities, carry the risk of default by the issuer. Two rating agencies, Standard & Poor's (S&P) Corporation and Moody's Investors Service Inc., provide investors with bond ratings, that is, current opinions on the relative quality of most large corporate and municipal bonds, as well as commercial paper. As independent organizations with no vested interest in the issuers, they can render objective judgments on the relative merits of their securities. By carefully analyzing the issues in great detail, the rating firms, in effect, perform the credit analysis for the investor. Standard & Poor's bond ratings consist of letters ranging from AAA, AA, A, BBB, and so on, to D. (Moody's corresponding letters are Aaa, Aa, A, Baa, etc., to D.) Plus or minus signs can be used to provide more detailed standings within a given category. The first four categories, AAA through BBB, represent investment grade securities. AAA securities are judged to have very strong capacity to meet all obligations, whereas BBB securities are considered to have adequate capacity. Typically, institutional investors must confine themselves to bonds in these four categories. Other things being equal, bond ratings and bond coupon rates are inversely related. Bonds rated BB,B,CCC, and CC are regarded as speculative securities in terms of the issuer's ability to meet its contractual obligations. These securities carry significant uncertainties, although they are not without positive factors. Bonds rated C are currently not paying interest, and bonds rated D are in default. Of the large number of corporate bonds outstanding, traditionally more than 8% have been rated A or better (based on the value of bonds outstanding). Utilities and finance companies have the fewest low-rated bonds, and transportation companies the most (because of problems with bankrupt railroads). Despite their widespread acceptance and use, bond ratings have some limitations. The two agencies may disagree on their evaluations. Furthermore, because most bonds are in the top four categories, it seems safe to argue that not all issues in a single category (such as A) can be equally risky. Finally, it is extremely important to remember that bond ratings are a reflection of the relative probability of default, which says little or nothing about the absolute probability of default. The following are Standard & Poor’s debt rating definitions: AAA - Extremely strong capacity to pay interest and repay principal AA - Strong capacity to pay interest and repay principal. A - Strong capacity to pay interest and repay principal but more vulnerable to an adverse change in conditions than in the case of AA. BBB - Adequate capacity to pay interest and repay principal. Even more vulnerable to adverse change in conditions than A-rated bonds. Debt rated BB and below is regarded as having predominantly speculative characteristics. BB - Less near-term risk of default than lower rated issues. These bonds are exposed to large ongoing uncertainties or adverse change in conditions. B - A larger vulnerability to default than BB but with the current capacity to pay interest and repay principal. CCC - A currently identifiable vulnerability to default and dependent on favorable conditions to pay interest and repay principal. CC - Applied to debt subordinated to senior debt rated CCC. C - Same as CC. D - A debt that is in default. + or - may be used to show relative standings within a category. Common Stock Valuation Methods Present Value Analysis There are no uniform rating services for common stock. The vagaries of the stock market as well as the complexities of this area results in greater variation of opinion as to the true or intrinsic value of a stock, as compared to bonds. There are two basic approaches to the valuation of common stocks using fundamental security analysis: The present value approach, also known as capitalization of income method The Price/ Earnings (P/E) approach The present value analysis is similar to a discounting process sometimes used for bonds. The future stream of cash flows to be received from a common stock is discounted back to the present at an appropriate discount rate, usually the investor’s required rate of return. We won’t attempt to teach the actual formula used, but the model would consist of three steps: Estimate an appropriate required rate of return Estimate the amount and timing of the future stream of cash flows. Use these two components in a present value model to estimate the value of the security, which is then compared to the current market price of the security. An investor who is considering the purchase of a common stock must assess its risk and, given its risk, determine the minimum expected rate of return that will be required to induce the investor to make the purchase. This minimum expected return or required rate of return, is an opportunity cost. The required rate of return, capitalization rate, and discount rate are interchangeable terms in valuation analysis. Regardless of which term is used, it is challenging to determine the numerical value to use for a particular stock. The other component that goes into the present value framework is the expected stream of cash flows. Just as the value of a bond is the present value of any interest payments plus the present value of the bond’s face value that will be received at maturity, the value of a common stock is the present value of all the cash flows to be received from the issuer (corporation). One needs to know the cash flows to use, the expected amounts of those cash flows, and when the cash flows will be received. Keep in mind that normally cash flows would include only dividends and the ultimate proceeds from the sale of the stock. Analysts use several models to discount future cash flows in this present value approach. While the average investor will not himself/herself use the models, it may be important to at least be familiar with their names. The dividend discount model, zero-growth model and constant growth model are all used. Intrinsic Value After making careful estimates of the expected stream of benefits and the required rate of return for a common stock, the intrinsic value of the stock is obtained through the present value analysis-that is, the dividend discount model. This is the objective of fundamental analysis. What does intrinsic value imply? Traditionally, investors and analysts specify a relationship between the intrinsic value (IV) of an asset and its current market price (CMP). Specifically: If IV > CMP, the asset is undervalued and should be purchased or held if already owned. If IV < CMP, the asset is overvalued and should be avoided or sold if held.. If IV = CMP, this implies an equilibrium in that the asset is correctly valued. An important question to ask at this point is, "What do you really have when you valued an asset by determining its intrinsic value?" The intrinsic value of an asset is that value that exists when the asset is correctly valued-its "true" value based on the capitalization of income process. Intrinsic value is simply the present value concept used in a financial context. A problem with intrinsic value is that it is derived from a present value process involving estimates of uncertain (future) benefits and use of (varying)- discount rates by different investors. Therefore, the same asset may have many intrinsic values-it depends on who, and how many, are doing the valuing. This is why, for a particular asset on a particular day, some investors are willing to buy and some to sell. Because future benefits are uncertain and investors have differing required rates of return, the use of fundamental valuation models will result in varying estimates of the intrinsic value of an asset. The market price of an asset at any point in time is, in this sense, the consensus intrinsic value of that asset for the market. The valuation process can establish justified prices for assets or indicate whether or not you can expect to earn your required rate of return on a prospective asset. Remember, however, that you are not assured of earning your required rate of return. Investment decisions always involve a forward-looking process. Estimates are made under uncertainty, based on the best information available. But even the best estimates may not be realized. Uncertainty will always be the dominant feature of the environment in which investment decisions are made. Furthermore, other factors are at play, including the psychology of the market. SEC filed company reports Price to Earnings Analysis The P/E ratio approach is probably more widely used by practicing security analysts. A stock is said to be worth some multiple of its future earnings. In effect, investors determine a stock’s value by deciding how many dollars (the multiple) they are willing to pay for every dollar of estimated earnings. Individual investors more commonly use this method as well and most publications and the press frequently refer to it. Earnings Estimates The conceptual framework for the P/E model is not as solidly based on economic theory as the present value models (such as the dividend discount model). However, a P/E ratio model is consistent with the present value analysis because it concerns the intrinsic value of a stock or the aggregate market, exactly as they do. The P/E ratio as reported daily in such sources as The Wall Street Journal is simply an identity calculated by dividing the current market price of the stock by the latest 12-month earnings. As such, it tells investors the price being paid for each $1 of earnings. Stock Quotes Another way of expressing the P/E ratio is Price = Estimated Earnings X Justified Multiple of Earnings When considering the P/E ratio as a valuation method keep in mind that the following relationships should hold, other things being equal: The higher the payout ratio of dividends, the higher the P/E The higher the expected growth rate, the higher the P/E The higher the required rate of return, the lower the P/E Most investors intuitively realize that the P/E ratio should be higher for companies whose earnings are expected to grow rapidly. However, how much higher is not an easy question to answer. The market will assess the degree of risk involved in the expected future growth of earnings- if the higher growth rate carries a high level of risk, the P/E ratio will be affected accordingly. Furthermore, the high growth rate may be attributable to several different factors, some of which are more desirable than others. For example, rapid growth in unit sales owing to strong demand for a firm’s products is preferable to favorable tax situations, which may change, or liberal accounting procedures, which one day may cause a reversal in the firm’s situation. The P/E ratio reflects investor optimism and pessimism. It is related to the required rate of return. As the required rate of return increases, other things being equal, the P/E ratio decreases. The required rate of return , in turn, is related to interest rates, which are the required returns on bonds. As interest rates increase, required rate of return on all securities, including stocks, also generally increase, As interest rate increase, bonds become more attractive compared to stocks on a current return basis. Based on these relationships, an inverse relationship between P/E ration and interest rate is to be expected. As interest rate rise, P/E ratios should decline. Alternative Valuation Techniques Investors use other valuation techniques, based on fundamental analysis concepts. Three that are fairly often referred to are price to book value, price/sales ratio and economic value added. Price to book value is calculated as the ratio of price to stockholders’ equity as measured on the balance sheet. It is sometimes use to value companies, particularly financial companies. Banks have often been evaluated using this ratio because the assets of banks have book values and market values that are similar. If the value of this ratio is 1.0, the market price is equal to the accounting (book) value. It is also used in merger and acquisition analysis. The price/sales ratio is a valuation technique that has received increased attention recently. This ratio is calculated as a company’s total market value (price times number of shares) divided by it sales, In effect, it indicates what the market is willing to pay for a firm’s revenues. The newest technique for evaluating stocks is to calculate the economic value added, or EVA. In effect, EVA is the difference between operating profits and a company’s true cost of capital for both debt and equity and reflects an emphasis on return on capital. I this difference is positive, the company has added value. Some studies have shown that stock price is more responsive to changes to EVA than to changes in earnings, the traditional variable of importance, Some mutual funds are now using EVA analysis as the primary tool for selecting stocks for the fund to hold. One recommendation for investors interested in this approach is to search for companies with a return of capital in excess of twenty percent because this will in all likelihood exceed the cost of capital, and, therefore, the company is adding value. Fundamental vs. Technical Analysis Fundamental analysis is based on the premise that any security (and the market as a whole) has an intrinsic value, or the true value as estimated by an investor. This value is a function of the firm’s underlying variables, which combine to produce an expected return and an accompanying risk. By assessing these fundamental determinants of the value of a security, an estimate of its intrinsic value can be determined. This estimated intrinsic value can then be compared to the current market price of the security. Similar to the decision rules used for bonds, decision rules are employed for common stocks when fundamental analysis is used to calculate intrinsic value. More on fundamental research In equilibrium, the current market price of a security reflects the average of the intrinsic value estimates made by investors. An investor whose intrinsic value estimate differs from the market price is, in effect, differing with the market consensus as to the estimate of either expected return or risk, or both. Investors who can perform good fundamental analysis and spot discrepancies should be able to profit by acting, before the market consensus reflects the correct information. Fundamental analysis is based on the premise that any security (and the market as a whole) has an intrinsic value, or the true value as estimated by an investor. This value is a function of the firm’s underlying variables, which combine to produce an expected return and an accompanying risk. By assessing these fundamental determinants of the value of a security, an estimate of its intrinsic value can be determined. This estimated intrinsic value can then be compared to the current market price of the security. Similar to the decision rules used for bonds, decision rules are employed for common stocks when fundamental analysis is used to calculate intrinsic value. In equilibrium, the current market price of a security reflects the average of the intrinsic value estimates made by investors. An investor whose intrinsic value estimate differs from the market price is, in effect, differing with the market consensus as to the estimate of either expected return or risk, or both. Investors who can perform good fundamental analysis and spot discrepancies should be able to profit by acting, before the market consensus reflects the correct information. Under either of the two fundamental approaches, an investor will have to work with individual company data. Does this mean that the investor should plunge into a study of company data first and then consider other factors such as the industry within which a particular company operates or the state of the economy, or should the reverse procedure be followed? In fact, each of these approaches is used by investors and security analysts when doing fundamental analysis. These approaches are referred to as the "top-down" approach and the "bottom-up" approach. With the "bottom-up" approach, investors focus directly on a company's basics, or fundamentals. Analysis of such information as the company's products, its competitive position, and its financial status leads to an estimate of the company's earnings potential, and, ultimately, its value in the market. Considerable time and effort are required to produce the type of detailed financial analysis needed to understand even relatively small companies. The emphasis in this approach is on finding companies with good long-term growth prospects, and making accurate earnings estimates. To organize this effort, bottom-up fundamental research is often broken into two categories, growth investing and value investing. Growth stocks carry investor expectations of above-average future growth in earnings and above-average valuations as a result of high price/ earnings ratios. Investors expect these stocks to perform well in the future, and they are willing to pay high multiples for this expected growth. Value stocks, on the other hand, feature cheap assets and strong balance sheets. Value investing can be traced back to the value-investing principles laid out by the well-known Benjamin Graham, who wrote a famous book on security analysis that has been the foundation for many subsequent security analysts. Growth stocks and value stocks tend to be in vogue over different periods, and the advocates of each camp prosper and suffer accordingly. In many cases bottom-up investing does not attempt to make a clear distinction between growth and value. Many companies feature strong earnings prospects and a strong financial base or asset value, and therefore have characteristics associated with both categories. Company Conference Calls The top-down approach is the opposite to the bottom-up approach. Investors begin with the economy and the overall market, considering such important factors as interest rates and inflation. They next consider likely industry prospects, or sectors of the economy that are likely to do particularly well (or particularly poorly). Finally, having decided that macrofactors are favorable to investing, and having determined which parts of the overall economy are likely to perform well, individual companies are analyzed. There is no "right" answer to which of these two approaches to follow. However, fundamental analysis can be overwhelming in its detail, and an investor should decide which approach seems more reasonable and try to develop a consistent method of action. Technical analysis can be defined as the use of specific market-generated data for the analysis of both aggregate stock prices (market indices or industry averages) and individual stocks. The technical approach to investing is essentially a reflection of the idea that prices move in trends which are determined by the changing attitudes of investors toward a variety of economic, monetary, political and psychological forces. The art of technical analysis - for it is an art - is to identify trend changes at an early stage and to maintain an investment posture until the weight of the evidence indicates that the trend is reversed. Technical Research tools Technical analysis is sometimes called market or internal analysis, because it utilizes the record of the market itself to attempt to assess the demand for, and supply of, shares of a stock or the entire market. Thus, technical analysts believe that the market itself is its own best source of data. Economics teaches us that prices are determined by the interaction of demand and supply. Technicians do not disagree, but argue that it is extremely difficult to assess all the factors that influence demand and supply. Since not all investors are in agreement on price, the determining factor at any point in time is the net demand (or lack thereof) for a stock based on how many investors are optimistic or pessimistic. Furthermore, once the balance of investors becomes optimistic (pessimistic), this mood is likely to continue for the near term and can be detected by various technical indicators. As the chief market technician of one New York firm says, "All I care about is how people feel about those particular stocks as shown by their putting money in and taking their money out." Technical analysis is based on published market data as opposed to fundamental data, such as earnings, sales, growth rates, or Government regulations. Market data include the price of a stock or the level of a market index, volume (number of shares traded), and technical indicators, such as the short interest ratio. Many technical analysts believe that only such market data, as opposed to fundamental data, are relevant. Recall that in fundamental analysis the dividend discount model produces an estimate of a stock's intrinsic value, which is then compared to the market price. Fundamentalists believe that their data, properly evaluated, indicate the worth or intrinsic value of a stock. Technicians, on the other hand, believe that it is extremely difficult to estimate intrinsic value and virtually impossible to obtain and analyze good information consistently. In particular, they are dubious about the value to be derived from an analysis of published financial statements. Instead, they focus on market data as an indication of the forces of supply and demand for a stock or the market. More Technical Data Technicians believe that the process by which prices adjust to new information is one of a gradual adjustment toward a new (equilibrium) price. As the stock adjusts from its old equilibrium level to its new level, the price tends to move in a trend. The central concern is not why the change is taking place, but rather the very fact that it is taking place at all. Technical analysts believe that stock prices show identifiable trends that can be exploited by investors. They seek to identify changes in the direction of a stock and take a position in the stock to take advantage of the trend. The following points summarize technical analysis: Technical analysis is based on published market data and focuses on internal factors by analyzing movements in the aggregate market, industry average, or stock. In contrast, fundamental analysis focuses on economic and political factors, which are external to the market itself. The focus of technical analysis is identifying changes in the direction of stock prices which tend to move in trends as the stock price adjusts to a new equilibrium level. These trends can be analyzed, and changes in trends detected, by studying the action of price movements and trading volume across time. The emphasis is on likely price changes. Technicians attempt to assess the overall situation concerning stocks by analyzing breadth indicators, market sentiment, and momentum. Technical analysis includes the use of graphs (charts) and technical trading rules and indicators. Price and volume are the primary tools of the pure technical analyst, and the chart is the most important mechanism for displaying this information. Technicians believe that the forces of supply and demand result in particular patterns of price behavior, the most important of which is the trend or overall direction in price. Using a chart, the technician hopes to identify trends and patterns in stock prices that provide trading signals. Stock Charts Volume data are used to gauge the general condition in the market and to help assess its trend. The evidence seems to suggest that rising (falling,) stock prices are usually associated with rising, (falling) volume. If stock prices rose but volume activity did not keep pace, technicians would be skeptical about the upward trend. An upward surge on contracting volume would be particularly suspect. A downside movement from some pattern or holding point, accompanied by heavy volume, would be taken as a bearish sign. Technical analysis has evolved over time, so that today it is much more than the charting of individual stocks or the market. In particular, technical analysts use indicators to assess market conditions (breadth) and investor sentiment. They also engage in "contrary analysis," which is an intellectual process more than a technique. The idea here is to go against the crowd when the crowd starts thinking alike. Technical analysis has, in some ways, entered into the mainstream of investment valuation processes. Many people who are not convinced totally of the merits of technical analysis still use tools developed by technicians, such as moving averages, relative strength and breadth indicators. Sentiment indicators are also widely used, such as short-interest ratio, the opinions of investment advisory services, mutual fund liquidity and CBOE put/call ratio.