Chapter 3 Important Investment Concepts Capital Markets Importance of Capital Markets In order to finance their operations as well as expand, business firms must invest capital in amounts that are beyond their capacity to save in any reasonable period of time. Similarly, governments must borrow large amounts of money to provide the goods and services that the people demand of them. The financial markets permit both business and government to raise the needed funds by selling securities. Simultaneously, investors with excess funds are able to invest and earn a return, enhancing their welfare. Financial markets are absolutely vital for the proper functioning of capitalistic economies, since they serve to channel funds from savers to borrowers. Furthermore, they provide an important allocative function by channeling the funds to those who can make the best use of them - presumably, the most productive. In fact, the chief function of a capital market is to allocate resources optimally. The existence of well-functioning secondary markets, where investors come together to trade existing securities, assures the purchasers of primary securities that they can quickly sell their securities if the need arises. Of course, such sales may involve a loss, because there are no guarantees in the financial markets. A loss, however, may be much preferred to having no cash at all if the securities cannot be sold readily. In the United States secondary markets are indispensable to the proper functioning of the primary markets. The primary markets, in turn, are indispensable to the proper functioning of the economy. Primary Market A primary market is one in which a borrower issues new securities in exchange for cash from an investor (buyer). New sales of Treasury bills, or IBM stock, or North Carolina bonds all take place in the primary markets. The issuers of these securities "the U.S. government, IBM, and the state of North Carolina, respectively," receive cash from the buyers of these new securities, who in turn receive financial claims that previously did not exist. Note that in all three of these examples, some amount of these securities is outstanding before the new sales occur. Sales of common stock of a publicly traded company are called seasoned new issues. If the issuer is selling securities for the first time, these are referred to as initial public offers (IPOs) Once the original purchasers sell the securities, they trade in secondary markets. New securities may trade repeatedly in the secondary market, but the original issuers will be unaffected in the sense that they receive no additional cash from these transactions. Secondary Markets Once new securities have been sold in the primary market, an efficient mechanism must exist for their resale if investors are to view securities as attractive opportunities. Secondary markets give investors the means to trade existing securities. Secondary markets exist for the trading of common and preferred stock, warrants, bonds, and puts and calls. Auction Markets Common stocks, preferred stocks, and warrants are traded in the equity markets. Some secondary equity markets are auction markets, involving an auction (bidding) process in a specific physical location. Investors are represented by brokers, intermediaries who represent both buyers and sellers and attempt to obtain the best price possible for either party in a transaction. Brokers collect commissions for their efforts and generally have no vested interest in whether a customer places a buy order or a sell order, or, in most cases, in what is bought or sold (holding constant the value of the transaction). The U.S. auction markets include the New York Stock Exchange, the American Stock Exchange, and the regional exchanges Negotiated Markets Negotiated markets involve the over-the-counter market. In contrast to auction markets, the over-the-counter (OTC) market is a negotiated market consisting of a network of dealers who make a market by standing ready to buy and sell securities at specified prices. Unlike brokers, dealers have a vested interest in the transaction because the securities are bought from them and sold to them, and they earn a profit in these trades by the spread, or difference, between the two prices. Transactions not handled on an organized exchange are handled in this market; that is, this market essentially handles unlisted securities, or securities not listed on a stock exchange, although some listed securities are now traded in this market. Thousands of stock trade in the OTC market, roughly 35,000, many of which are small, thinly traded stocks that do not generate much interest. The most important part of the negotiated market is the Nasdaq Stock Market, or Nasdaq, a national and international stock market consisting of communications networks for the trading of thousands of stocks. Technically, Nasdaq has insisted for several years that its market is not synonymous with the OTC market. This market is a wholly owned subsidiary of the National Association of Securities Dealers, a self-regulating body of brokers and dealers that oversees OTC practices, much as the NYSE does for its members. Unlike the NYSE, the Nasdaq Stock Market does not have a specific location. Rather, it is a way of doing business. It consists of a network of market makers or dealers linked together by communications devices who compete freely with each other through an electronic network of terminals, rather than on the floor of an exchange. These dealers conduct transactions directly with each other and with customers. Each Nasdaq company has a number of competing dealers who make a market in the stock, with a minimum of two and an average of 11. Third and Fourth Markets All off-exchange transactions in securities listed on the organized exchanges take place in the so-called third market. By the beginning of the 1990s, the third market had become the third largest trader of NYSE-listed stocks. The fourth market refers to transactions made directly between large institutions (and wealthy individuals), bypassing brokers and dealers. Essentially, the fourth market is a communications network among investors interested in trading large blocks of stock. Several different privately owned automated systems exist to provide current information on specific securities that the participants are willing to buy or sell. Developing Reasonable Expectations What type of return should one expect from his or her investments? Obviously that depends to a great extent upon the investment itself. Generally, the higher the risk, the higher is the potential reward. It would be irrational to take on additional risk without at least a commensurate reward potential. We can assume that most investors will apply the sound practice of diversification of their assets in order to obtain a "blend" of risk and reward. Expectation of return is extremely important in the "planning" portion of financial planning. When planning for future retirement needs, for example, one must make some assumptions regarding anticipated rates of return. A variation of only two or three percentage points can make a huge difference in the projected ending balance of a retirement savings program over twenty or thirty years. Many financial planners are reporting what they believe to be excessive and unrealistic expectations by some clients, especially in regards to stock market returns. During the decade of the 1990’s, the average annual compound return of the Dow Jones Industrial Average was 18.4%. On the heels of that performance, a Gallup poll showed that investors younger than forty as a group expect average returns of 22% a year for the first decade of the twenty-first century. Are these expectations indeed too high? A historical perspective may be helpful. If one looks at all rolling ten-year periods since 1928,(ex. 1928-1937, 1929-1938,etc.) through 1999, the DJIA’s returns have exceeded 18% only six times. The average annual return for that entire period has been around 12 %, aided greatly by the returns of the last fifteen years. As a result, most financial planners would advise one to use expected returns from the stock portion of their investments in the 9% to 12% range. Expected returns for the fixed income portion should generally be based upon a lower historical return of 5% to 7%. Having realistic expectations should result in better planning and help reduce the possibility of serious disappointment. Evaluating Personal Tax Situations There are now five marginal tax rates for IRS purposes: 15, 28, 31, 36, and 39.6 percent. Any state income taxes also must be considered and could easily raise the effective marginal tax rate several percentage points. Investors must distinguish between short-term and long-term capital gains. The holding period to become a long-term capital gain or loss was raised to one year or more from the previous six months for property acquired after 1987. By 1991 the maximum tax rate on net capital gains was 28 percent, restoring the distinction between ordinary income and capital gains that was eliminated by the 1986 act. This rate applies to net capital gains, defined as net long-term gains less net short-term losses. Long-term capital gains can be offset with long-term capital losses on a dollar-for-dollar basis, and the same is also true for short-term gains and losses. Finally, offsetting net long-term gains with net short-term losses produces the net capital gains referred to above. Up to $3,000 of net capital loss can be used for the current tax year to offset ordinary income, and the balance can be carried forward. It is important to note that capital gains and losses can be unrealized or realized. Tax implications occur when an investor sells a capital asset. Until an actual sale occurs, the gain or loss is not "realized," and therefore no tax is due. Most investment income will be subject to taxes at some time, although various procedures such as tax-deferred retirement plans can delay that date for a long time. The only exception for most investors is the income from municipal bonds, and even that may be subject to state taxes. Taxes have a significant impact on investor returns and should be carefully considered in making investment decisions. For example, the 10 largest equity mutual funds returned an average annualized total return of 14.9 percent for the five years ending in 1993. After taxes, the return was 10.8 percent, a 28 percent difference (assuming reinvestment of distributions after taxes were paid at the highest federal rates in effect at the time, and the sale of shares and payment of capital gains taxes at the end of the period) Qualified vs. Taxable Monies For many individuals, one of the most important reasons for saving and investing is to create funds which can be used to provide a nest egg during retirement. The single most important tool available for this purpose is the utilization of "qualified monies." This refers to money placed in accounts that are denoted as qualified plans by the U.S. Government. These numerous plans which include 401 (k) plans, IRAs, pension plans, profit-sharing plans, etc. are accounts designed to provide companies and individuals with special savings incentives. While the rules governing the various plans vary, they generally provide tax benefits not available in regular taxable accounts. Some plans provide tax benefits at the time of contribution and all provide the all-important feature of tax deferral. Earnings realized in the accounts are not taxed annually as in taxable accounts and thereby enable the account to grow larger than would otherwise be possible. Taxation is deferred until withdrawals are made during retirement years when one may be in a lower income tax bracket. Because this significant tax break is intended to enhance retirement savings, there are, in most cases, rather severe penalties for withdrawals made prematurely (usually prior to age 59 ½). The premature distributions penalties make it necessary for most people to have taxable savings in addition to their retirement savings to cover normal consumption and liquidity needs and anticipated future expenses that may arise prior to retirement. Because of the dual benefits of tax deferral and compounding of interest, the more money someone can contribute to a qualified plan at an early age, the better. However, most young people are also facing large future expenses associated with marriage, starting a family, home purchase, college education funding for children, etc. Many younger employees, then, find themselves walking a financial tight rope in deciding how much of their total savings to devote to a qualified plan (with better earnings potential but illiquid because of premature distribution penalties) and how much to devote to regular taxable accounts ( which are easily accessible but don’t provide the tax benefits of a qualified plan). For many employed persons who are older, own their home and are focused on the more rapidly approaching event of retirement, the decision is much easier. Many attempt to contribute the maximum amount allowable by law to qualified plans. In any case, almost everyone should be aware of the advantages of these plans and utilize them to the extent they can. Financial advisors will almost always begin the process of financial planning by exploring qualified plan alternatives. Remember, all other things being equal, money in a qualified plan will grow quicker than in a taxable account. When gains from investments, including dividends and capital gains, compound without paying current income taxes, the results can be remarkable. Don’t overlook the role of qualified plans in your quest to build personal wealth. Assessing Your Level of Knowledge and Experience In the past, investment knowledge and experience wasn’t always essential. Many companies offered their employees guaranteed pensions they could depend upon at retirement. Today, most employees must be at least partially responsible for their own retirement planning. And with fiduciary responsibility a key legal issue, many individuals must take responsibility for how retirement savings are invested. There’s increased market volatility and overwhelming media hype and stock market coverage. There’s online trading, day trading and the extremely active arena of technology stocks. There are many new investment issues we face today and they can be confusing. One thing is clear: investing is an individual’s responsibility; ultimately, responsible investing begins and ends with you. We are investors for our entire adult lives, whether we want to be or not. It’s about setting goals, building a plan and sticking to the fundamentals in order to reach those goals. It’s about keeping your plan on track when the market goes through its inevitable ups and downs, despite the distracting headlines and all the resulting doom and gloom. One should be able to develop an investment plan, complete with investment policy statement. The nuances of risk/reward relationships, asset allocation, diversification and various investment products and strategies should be familiar. You don’t live for today, and most of us don’t just live for ourselves. We have family and responsibilities. Most of us don’t invest just to make money, but rather to reach our goals and take care of those responsibilities. Like providing for our children’s education, retiring comfortably, taking care of our parents if they need our help, and making sure we’ll have something to pass on to future generations. Some people rightfully feel they have the knowledge and experience to create a financial plan, invest, measure and monitor results completely on their own. Others feel they are better served and benefit from the assistance of a qualified, experienced financial advisor. It may be helpful to order a Financial Planning Resource Kit from the Certified Financial Planner Board of Standards (Link to site here). Brochures they offer for free include, "What you should know about financial planning," and "10 Questions to ask when choosing a financial planner." You can also check the disciplinary history of a financial planner or advisor by making toll free phone calls to the following associations and agencies: National Association of Securities Dealers 800-289-9999 Securities and Exchange Commission 800-732-0330 National Association of Insurance Commissioners 816-842-3600 888-237-6275 Preferences and Risk Tolerance There is a trade-off between expected return and risk that should prevail in a rational environment. Investors unwilling to assume risk must be satisfied with the risk-free rate of return, . If they wish to try to earn a larger rate of return, they must be willing to assume a larger risk as represented by moving up the expected retum-risk trade-off into the wide range of financial assets available to investors. Although all rational investors like returns and dislike risk, they are satisfied by quite different levels of expected return and risk. Put differently, investors have different limits on the amount of risk they are willing to assume and, therefore, the amount of return that can realistically be expected. In economic terms, the explanation for these differences in preferences is that rational investors strive to maximize their utility, the perception of which varies among investors. Always remember that the risk-return trade-off is ex ante, meaning "before the fact." That is, before the investment is actually made, the investor expects higher returns from assets that have a higher risk. This is the only sensible expectation for risk-averse investors, who are assumed to constitute the majority of all investors. Ex post (meaning "after the fact" or when it is known what has occurred), for a given period of time, such as a month or a year or even longer, the trade-off may turn out to be flat or even negative. Such is the nature of risky investments Investors can choose from a wide range of securities in their attempt to maximize the expected returns from these opportunities. They face constraints, however, the most pervasive of which is risk. Traditionally, investors have analyzed and managed securities using a broad two-step process: security analysis and portfolio management. The first part of the investment decision process involves the valuation and analysis of individual securities, which is referred to as security analysis. Professional security analysts are usually employed by institutional investors. Of course, there are also millions of amateur security analysts in the form of individual investors. The valuation of securities is a time-consuming and difficult job. First of all, it is necessary to understand the characteristics of the various securities and the factors that affect them. Second, a valuation model is applied to these securities to estimate their price, or value. Value is a function of the expected future returns on a security and the risk attached. Both of these parameters must be estimated and then brought together in a model. For bonds, the valuation process is relatively easy, because the returns are known and the risk can be approximated from currently available data. This does not mean, however, that all the problems of bond analysis are easily resolved. Interest rates are the primary factor affecting bond prices, but no one can consistently forecast changes in these rates. The valuation process is much more difficult for common stocks than for bonds. The investor must deal with the overall economy, the industry, and the individual company. Both the expected return and the risk of common stocks must be estimated. Despite the difficulties, some type of analysis must be performed by investors serious about their portfolios. Unless this is done, one has to rely on personal hunches, suggestions from friends, and recommendations from brokers-all potentially dangerous to one's financial health. The secondary major component of the decision process is portfolio management. After securities have been evaluated, a portfolio should be selected. Concepts on why and how to build a portfolio are well known. Much of the work in this area is in the form of mathematical and statistical models, which have had a profound effect on the study of investments in this country in the last 30 years. Having built a portfolio, the astute investor must consider how and when to revise it. This raises a number of important questions. Portfolios must be managed, regardless of whether an investor is active or passive. If the investor pursues an active strategy, the issue of market efficiency must be considered. If prices reflect information quickly and fully, investors should consider how this will affect their buy and sell decisions. Even if investors follow a passive strategy, questions to be considered include taxes, transaction costs, maintenance of the desired risk level, and so on. Finally, all investors are interested in how well their portfolio performs. This is the bottom line of the investment process. Measuring portfolio performance is an inexact procedure, even today, and needs to be carefully considered. Probability Distributions To deal with the uncertainty of returns, investors need to think explicitly about a security’s distribution of probable TRs. In other words, investors need to keep in mind that, although they may expect a security to return 10 perfect, for example, this is only a one-point estimate of the entire range of possibilities. Given that investors must deal with the uncertain future, a number of possible returns can, and will, occur. In the case of a Treasury bond paying a fixed rate of interest, the interest payment will be made with 100 percent certainty barring a financial collapse of the economy. The probability of occurrence is 1.0, because no other outcome is possible. With the possibility of two or more outcomes, which is the norm for common stocks, each possible likely outcome must be considered and a probability of its occurrence assessed. The result of considering these outcomes and their probabilities together is a probability distribution consisting of the specification of the likely returns that may occur and the probabilities associated with these likely returns. Probabilities represent the likelihood of various outcomes and are typically expressed as a decimal. (Some fractions are used.) The sum of the probabilities of all possible outcomes must be 1.0, because they must completely describe all the (perceived) likely occurrences. How are these probabilities and associated outcomes obtained? In the final analysis, investing for some future period involves uncertainty, and therefore subjective estimates. Although past occurrences (frequencies) may be relied on heavily to estimate the probabilities, the past must be modified for any changes expected in the future. Probability distributions can be either discrete or continuous. With a discrete probability distribution, a probability is assigned to each possible outcome. To describe the single arithmetic vs. geometric most likely outcome from a particular probability distribution, it is necessary to calculate its expected value. The expected value is the average of all possible return outcomes, where each outcome is weighted by its respective probability of occurrence (multiply return by probability and add them). Since investors are interested in returns, we will call this expected value the expected rate of return, or simply expected return, and for any security. Trading vs. Investing Investing is a complex field of study involving knowledge of a myriad of investment vehicles, terms, concepts, strategies and processes. In the practical world of investing that study is best accompanied by training and experience. The lifetime pursuit of financial goals allows for few short cuts in this area. However, since the very beginning of the U.S. stock market there have always been some individuals who have attempted to trade stocks actively in order to capture more profits than losses and hopefully produce a net gain. For most of stock market history, execution of trades could be accomplished for most investors only through the services of a stockbroker. In the last couple of decades with technological and regulatory advancements, execution of trades has been made accessible to individuals themselves through discount brokers and on-line trading firms. Unfortunately, some individuals have confused the ability to execute a transaction with the ability to effectively manage their investable assets. Some one who has the knowledge, training and experience to perform financial planning without the aid of a financial planner does not necessarily need a planner, advisor or broker to execute a stock trade. However, being able to execute a stock trade in no way lessons the importance of knowledge, training and experience in the lifetime pursuit of financial goals. If after taking the steps necessary to create a working financial plan (with or without the assistance of a financial planner), the asset allocation model indicates a portion of assets could be allocated to short-term aggressive trading and you have the risk tolerance for it, then and only then should actively trading stocks be considered. To do otherwise is throwing caution to the wind. Bond Price Changes As A Result Of Interest Rate Changes Bond prices change because interest rates and required yields change. Understanding how bond prices change given a change in interest rates is critical to successful bond management. The basics of bond price movements as a result of interest rate changes have been known for many years. For example, over 30 years ago Burton Malkiel derived five theorems about the relationship between bond prices and yields. Using the bond valuation model, he showed the changes that occur in the price of a bond (i.e., its volatility), given a change in yields, as a result of bond variables such as time to maturity and coupon. We will use Malkiels’s bond theorems to illustrate how bond prices change as a result of changes in interest rates. Bond Prices Move Inversely to Interest Rates Investors must always keep in min a fundamental fact about the relationship between bond prices and bond yields: Bond prices move inversely to market yields. When the level of required yields demanded by investors on new issues changes, the required yields on all bonds already outstanding will also change. For these yields to change, the prices of these bonds must change. This inverse relationship is the basis for understanding, valuing, and managing bonds. An interesting corollary of the inverse relationship between bond prices and interest rates is as follows: Holding maturity constant, a decrease in rates will raise bond prices on a percentage basis more than a corresponding increase in rates will lower bond prices Obviously, bond price volatility can work for, as well as against, investors. Money can be made, and lost, in risk-free Treasury securities as well as more risky corporate bonds. Although the inverse relationship between bond prices and interest rates is the basis of all bond analysis, a complete understanding of bond price changes as a result of interest rate changes requires additional information. An increase in interest rates will cause bond prices to decline, but the exact amount of decline will depend on important variables unique to each bond such as time to maturity and coupon. The effect of a change in yields on bond prices depends on the maturity of the bond. An important principle is that for a given change in market yields, changes in bond prices are directly related to time to maturity. Therefore, as interest rates change, the prices of longer-term bonds will change more than the prices of shorter-term bonds will change more than the prices of shorter term bonds, everything else being equal. The principle illustrated here is simple but important. Other things being equal, bond price volatility is a function of maturity. Long-term bond prices fluctuate more than do short-term bond prices. A related principle regarding maturity is as follows: The percentage price change that occurs as a result of the direct relationship between a bond’s maturity and its price volatility increases at a diminishing rate as the time to maturity increases. This example shows that the percentage of price change resulting from an increase in time to maturity increases, but at a decreasing rate. Put simply, a doubling of the time to maturity will not result in a doubling of the percentage price change resulting from a change in market yields. In addition to the maturity effect, the change in the price of a bond as a result of a change in interest rates depends on the coupon rate of the bond. We can state this principle as (other things equal): Bond price fluctuations (volatility) and bond coupon rates are inversely related. Note that we are talking about percentage price fluctuations; this relationship does not necessarily hold if we measure volatility in terms of dollar price changes rather than percentage price changes. The Implications of Malkiel’s Theorems for Investors Malkiel’s derivations for bond investors lead to the practical conclusion that the two bond variables of major importance in assessing the change in the price of a bond, given a change in interest rates, are its coupon and its maturity. This conclusion can be summarized as follows: A decline (rise) in interest rates will cause a rise (decline) in bond prices, with the most volatility in bond prices occurring in longer maturity bonds and bonds with low coupons. Therefore: A bond buyer, in order to receive the maximum price impact of an expected change in interest rates, should purchase low-coupon, long-maturity bonds. If an increase in interest rate sis expected (or feared), an investor contemplating their purchase should consider those bonds with large coupons or short maturities, or both. These relationships provide useful information for bond investors by demonstrating how the price of a bond changes as interest rates change. Although investors have no control over the change and direction in market rates, they can exercise control over the coupon and maturity, both of which have significant effects on bond price changes. Nevertheless, it is cumbersome to calculate various possible price changes on the basis of these theorems. Furthermore, maturity is an inadequate measure of the sensitivity of a bond’s price change to changes in yields because it ignores the coupon payments and the principal repayment. Investors managing bond portfolios need a measure of time designed to more accurately portray a bond’s “average” life, taking into account all of the bond’s cash flows, including both coupons and the return of principal at maturity. Such a measure, called duration, is available and is widely used today. In managing a bond portfolio, perhaps the most important consideration is the effect of yield changes on the prices and rates of return for different bonds. The problem is that a given change in interest rates can result in very different percentage price changes for the various bonds that investors hold. We saw earlier than both maturity and coupon affect bond price changes for a given change in yields. Although maturity is the traditional measure of a bond’s lifetime, it is inadequate, because it focuses only on the return of principal at the maturity date. Two 20-year bonds, one with an 8 percent coupon and the other with a 15 percent coupon, do not have identical economic lifetimes. An investor will recover the original purchase rice much sooner with the 15 percent coupon bond. Therefore, a measure is needed that accounts for the entire pattern (both size and timing) of the cash flows over the life of the bond – the effective maturity of the bond. Such a concept, called duration, was conceived over 50 years ago by Frederick Macaulay. Duration is very useful for bond management purposes because it combines the properties of maturity and coupon. Duration measures the weighted average maturity of a bond’s cash flows on a present value basis; that is, the present values of the cash flows are used as the weight sin calculating the weighted average maturity. Thus, Duration = number of years needed to fully recover purchase price of a bond, given present values of its cash flows Duration= weighted average time to recovery of all interest payments plus principal

Check Your Knowledge: Mini-Quiz: Evaluating Returns (Risk vs. Reward)