Chapter 10 - lecture 10 NOTES PDF

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Chapter 10: Investing fundamentals L.O.1-Types of Investments 1) Money Market Securities There are several different savings alternatives available, including term deposits, guaranteed investment certificates (GICs), Canada Savings Bonds (CSBs), and money market funds. Most money market securities provide interest income. Even if your liquidity needs are covered, you may invest in these securities to maintain a low level of risk. Yet, you can also consider some alternative securities that typically provide a higher rate of return but are riskier. 2) Stocks As defined in Chapter 3 , s tocks are certificates that represent partial ownership of a firm. Firms issue shares to obtain funds to expand their business operations. Investors buy shares when they believe that they may earn a higher return than those offered on alternative investments. Since shares are a popular type of investment, they are the focus of Chapter 11 . Primary and Secondary Stock Markets. Shares can be traded in a primary or a secondary market. The primary market is a market in which newly issued securities are traded. Firms can raise funds by issuing new shares in the primary market. The first offering of a firm’s shares to the public is referred to as an initial public offering (IPO) . A secondary market facilitates the trading of existing securities, which allows investors the opportunity to sell their shares to other investors at any time. These shares are purchased by other investors who wish to invest in that company. Thus, even if a firm is not issuing new shares, investors can easily obtain that firm’s shares by purchasing them in the secondary market. On a typical day, more than one million shares of any large firm are traded in the secondary market. The price of the shares changes each day in response to fluctuations in supply and demand. Types of Stock Investors. Stock investors can be classified as institutional investors or individual investors. Institutional investors are professionals employed by a financial institution who are responsible for managing large pools of money on behalf of their clients. A pension fund, such as the Ontario Teachers’ Pension Plan, is an example of a pool of money managed on behalf of clients. Institutional investors, also known as portfolio managers, attempt to select stocks or other securities that will provide a reasonable return on investment. More than half of all trading in financial markets is attributable to institutional investors. Individual investors commonly invest a portion of their income in stocks. Like institutional investors, they invest in stocks to earn a potentially better or higher return on their investment. In this way, their money can grow by the time they want to use it. The number of individual investors has increased substantially in the last 20 years. Many individual investors hold their stocks for periods beyond one year. In contrast, some individual investors called day traders buy stocks and then sell them on the same day. They hope to capitalize on very short-term movements in security prices. In many cases, their investments may last for only a few minutes. Many day traders conduct their investing as a career, relying on their returns as their main source of income. This type of investing is very risky and requires skill, nerves, and capital. Day trading is not recommended for most investors. Return from Investing in Stocks. Stocks can offer a return on investment through dividends and/or stock price appreciation. Some firms distribute quarterly income to their shareholders in the form of dividends rather than reinvest the earnings in their operations. They tend to keep the dollar amount of the dividends per share fixed from one quarter to the next, but may periodically increase the amount. They rarely reduce the dividend amount unless they experience relatively weak performance and cannot afford to make their dividend payments. The amount of dividends paid out per year is usually between 1 and 3 percent of the stock’s price.

A firm’s decision to distribute earnings as dividends may depend on the opportunities available to it. In general, firms that pay high dividends tend to be older, established firms that have less chance of substantial growth. Conversely, firms that pay low dividends tend to be younger firms that have more growth opportunities. The shares of firms with substantial growth opportunities are often referred to as growth stocks . An investment in these younger firms offers the prospect of a very large capital gain because they have not yet reached their full potential. At the same time, investment in these firms is exposed to much higher uncertainty because young firms are more likely than mature firms to fail or experience very weak performance. Value stocks are another type of stock investment that offers the prospect of a substantial return. However, the returns on these stocks may not be based on the growth opportunities available to the firm. Instead, value stocks represent the stocks of firms that are currently undervalued by the market for reasons other than the performance of the businesses themselves. Value stocks are usually not newsworthy because they are often not associated with up-and-coming younger firms. As a result,the assets of value stocks are often underappreciated, and undervalued by the market. A knowledgeable investor will recognize the hidden value in these stocks and purchase shares in the hope that the stock will eventually be recognized for its true potentialby other investors. The higher the dividend paid by a firm, the lower its potential stock price appreciation. When a firm distributes a large proportion of its earnings to investors as dividends,it limits its potential growth and the potential degree to which its value (and stock price)may increase. Stocks that provide investors with periodic income in the form of large dividends are referred to as income stocks . Shareholders can also earn a return if the price of the stock appreciates (i.e., increases)by the time they sell it. The market value of a firm is based on the number of shares of stock outstanding multiplied by the price of the stock. The price of a share of stock is determined by dividing the market value of the firm by the number of shares of stock outstanding. Therefore, a firm that has a market value of $600 million and 10 million shares of stock outstanding has a value per share of: Value of Stock per Share = Market Value of Firm ÷ Number of Shares Outstanding = $600 000 000 ÷ 10 000 000 = $60 The market price of a stock depends on the number of investors willing to purchase the stock (the demand) and the number of investors wanting to sell their stock (the supply). There is no limit to how high a stock’s price can rise. The demand for the stock and the supply of stock for sale are influenced by the respective firm’s business performance, as measured by its earnings and other characteristics. When the firm performs well, its stock becomes more desirable to investors, who demand more shares. In addition, investors holding shares of this stock are less willing to sell it. The increase in the demand for the shares and the reduction in the number of shares for sale results in a higher stock price. Conversely, when a firm performs poorly (has low or negative earnings), its market value declines. The demand for shares of its stock also declines. In addition, some investors who had been holding the stock will decide to sell their shares, thereby increasing the supply of stock for sale and resulting in a lower price. The performance of the firm depends on how well it is managed. Investors benefit when they invest in a well-managed firm because the firm’s earnings usually will increase, and so will its stock price. Under these conditions, investors may generate a capital gain, which represents the difference between their selling price and their purchase price. In contrast, a poorly managed firm may have lower earnings than expected, which could cause its stock price to decline. Common versus Preferred Stocks. Stocks can be classified as common stock or preferred stock. Common stock is a certificate issued by a firm to raise funds that represents partial ownership in the firm. Investors who hold

common stock normally have the right to vote on key issues such as the sale of the company. They elect the board of directors, which is responsible for ensuring that the firm’s managers serve the interests of its shareholders. In general, investors who purchase common stock are seeking a return on their investment from stock price appreciation, rather than dividends. Nevertheless, many companies that issue common stock also pay dividends to investors. Preferred stock is a certificate issued by a firm to raise funds that entitles shareholders to first priority (ahead of common stockholders) to receive dividends. Investors who purchase preferred stock are seeking the regular income that comes from dividend payments rather than the potential for stock price appreciation. The price of preferred stock is not as volatile as the price of common stock and does not have as much potential to increase substantially. For this reason, investors who strive for high returns typically invest in common stock, while those interested in income purchase preferred shares. Corporations issue common stock more frequently than preferred stock. 3) Bonds Recall that bonds are long-term debt securities issued by government agencies or corporations. Government bonds are issued by the Bank of Canada on behalf of the federal government and backed by the Canadian government. Corporate bonds are issued by corporations. Return from Investing in Bonds. Bonds offer a return to investors in the form of fixed interest (coupon) payments and bond price appreciation. Bonds are desirable for investors who want their investments to generate a specific amount of income each year. 4) Mutual Funds Mutual funds sell units to individuals and invest the proceeds in a portfolio of investments that may include money market securities, stocks, bonds, and other investment types. They are managed by experienced portfolio managers and are attractive to investors who have limited funds and want to invest in a diversified portfolio. Return from Investing in Mutual Funds. Since a mutual fund represents a portfolio of securities, its value changes over time in response to changes in the values of the various types of investments it is made up of. Investors who own a mutual fund may earn a return from interest income, dividends, and/or the price appreciation of the investments in the fund. 5) Real Estate One way of investing in real estate is to buy a home. For many individuals, the purchase of their first home is the largest real estate investment they will ever make. The value of a home changes over time in response to supply and demand. When the demand for homes in your area increases, home values tend to rise. The return that you earn on your home is difficult to measure because you must take into account the upfront financing costs, the costs associated with selling the home, and carrying costs, such as mortgage interest and property taxes. However, a few generalizations are worth mentioning. For a given amount invested in the home, your return depends on how the value of your home changes over the time you own it. Your return also depends on your original down payment on the home. The return will be lower if you made a smaller down payment when purchasing the home because interest and other costs will be higher. Since the value of a home can also decline over time, there is the risk of a loss (a negative return) on your investment. If you are in a hurry to sell your home, you may have to lower your selling price to attract potential buyers, which will result in a lower return on your investment. You can also invest in real estate by purchasing rental property or land. A rental property may include the purchase of additional homes, apartments, office buildings, or other commercial property. These properties can then be leased out to generate a rental income. If you are looking

to sell these properties, they may also generate a capital gain or loss based on the supply and demand of similar properties in the area. Similarly, the price of land is also based on supply and demand. When there is little open land and dense population, as is the case in southern Ontario, land typically sells for a higher price. Return from Investing in Real Estate. As has been discussed, real estate, such as office buildings and apartments, can be rented to generate income in the form of rent payments. In addition, investors may earn a capital gain if they sell a rental property for a higher price than they paid for it. Alternatively, they may sustain a capital loss if they sell the property for a lower price than they paid for it. With respect to your principal residence, any capital gains are usually exempt from taxation. The price of land changes over time in response to real estate development. Many individuals may purchase land as an investment, hoping that they will be able to sell it in the future for a higher price. L.O.2- Investment Return and Risk When individuals consider any particular investment, they must attempt to assess two characteristics: the potential return that will be earned on the investment and the risk of the investment. Measuring the Return on Your Investment For investments that do not provide any periodic income (such as dividends or interest payments), the return can be measured as the percentage change in the price ( P ) from the time the investment was purchased (time t – 1) until the time at which it is sold (time t ): R =Pt - Pt-1/Pt-1 For example, if you pay $1000 to make an investment and receive $1100 when you sell the investment one year later, you earn a return of: R = $1100 - $1000/$1000 = 0.10, or 10% Incorporating Dividend or Coupon Payments. If you also earned dividend or interest payments over this period, your return would be even higher. For a short-term period such as one year or less, the return on a security that pays dividends or interest can be estimated by adjusting the equation above. Add the dividend or interest amount to the numerator. The return on your investment accounts for any dividends or interest payments you received as well as the change in the investment value over your investment period. For stocks that pay dividends, the return is: R = (Pt - Pt-1) + D/Pt-1 where R is the return, P t – 1 is the price of the stock at the time of the investment, P t is the price of the stock at the end of the investment horizon, and D is the dividends earned over the investment horizon. Here’s an example: You purchased 100 shares of Wax Inc. stock for $50 per share one year ago. The firm experienced strong earnings during the year. It paid dividends of $1 per share over the year and you sold the stock for $58 per share at the end of the year. Your return on your investment was: R = (Pt - Pt-1) + D/Pt-1= ($58 - $50) + $1 =$50= = 0.18, or 18% Differing Tax Rates on Returns. Recall from Chapter 4 that incomes received from interest payments, dividend payments, and capital gains are treated differently for tax purposes. An investor who receives $1000 of capital gains or dividend income will pay less tax than an investor who receives $1000 of interest income. Individuals who are in the highest marginal tax bracket will pay the most amount of taxes on capital gains. At lower marginal tax brackets, eligible dividend payments from large corporations that qualify for the enhanced dividend tax credit will result in the least amount of tax payable. How Wealth Is Influenced by Your Return on Investment

When an investment provides income to you, any portion of that income that you save will increase the value of your assets. For example, if you receive a coupon payment of $100 this month as a result of holding a bond and deposit the proceeds in your savings account, your assets will increase by $100. If the value of your investments increases and your liabilities do not increase, your wealth increases. The degree to which you can accumulate wealth partially depends on your investment decisions. You can estimate the amount by which your wealth will increase from an investment based on some assumed rate of return. The following example shows how your investment decisions and the performance of your investments can affect your future wealth. L.o.3- Risk of Investing The risk of an investment comes from the uncertainty surrounding its return. The return you will earn on a specific stock is uncertain because its future dividend payments are not guaranteed and its future price (when you sell the stock) is uncertain. The return you will earn on a bond is uncertain because its coupon payments are not guaranteed and its future price (when you sell the bond) is uncertain when you sell the bond before it matures. The return you will earn from investing in real estate is uncertain because rental income may not be paid and its value when you sell it is uncertain. Unsystematic and Systematic Risk. The specific risks of various types of investments are commonly referred to as unsystematic risks. An unsystematic risk is a risk that is specific to a company, an industry, or a country. For example, a poorly managed company may suffer a decrease in its stock price. This is an example of business management risk. Diversification and asset allocation can be used to eliminate, or at least minimize, unsystematic risk. Systematic risk is risk that affects all companies, industries, and countries. It is a category of risk that cannot be avoided. For example, many firms suffered a significant decrease in their stock price when Lehman Brothers went bankrupt during the 2008–2009 credit crisis. Many stocks of large, well-known companies experienced price declines of 40 percent or more during the credit crisis. The impact of systematic risk is usually even greater on small company stocks since their earnings are more volatile. Although some firms are more stable than others and are therefore less likely to experience a major decline in their market value, some investors prefer investments that have a higher growth potential, and they tolerate the higher level of risk. Before you select an investment, you should assess the risk of the investment and weigh this risk against your own risk tolerance. By diversifying your portfolio and allocating your assets across a number of different types of investment, you can reduce some of the risk in your portfolio of investments. Measuring an Investment’s Risk. Investors measure the risk of investments to deter mine the degree of uncertainty surrounding their future returns. Three common measures of an investment’s risk are its range of returns, the standard deviation of its returns, and its beta. These measures can be applied to investments whose prices are frequently quoted over time. Range of Returns. By reviewing the monthly returns of a specific investment over a given period, you can determine the range of returns , from the smallest (most negative) to the largest return. Compare an investment that has a range of monthly returns from 0.2 percent to 1.4 percent over the last year with an investment that has a range of 23.0 percent to 4.3 percent. The first investment is less risky because its range of returns is smaller and therefore it is more stable. Investments with a wide range have more risk because they have a higher probability of experiencing a large decline in price. Standard Deviation of Returns. A second measure of risk is the standard deviation of an investment’s monthly returns, which measures the degree of volatility in the investment’s returns over time. A large standard

deviation means that the returns deviate substantially from the mean over time. The more volatile the returns, the greater the chance that the stock could deviate far from its mean in a given period. Thus, an investment with a high standard deviation is more likely to experience a large gain or loss in a given period. The investment’s return is subject to greater uncertainty, and for this reason it is perceived as riskier. Beta. A third measure of an investment’s risk is its beta , which measures the systematic risk of an investm...