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Chapter 2:The investment Process.
Investment Policy Statements: Divided into 2 sections:
Objectives and Constraints.
o Objectives (Risk and Return): Most investors are risk averse,
meaning that, all else equal, they dislike ris
and want to expose themselves to the minimum risk level
possible.
o Investor Constraints: We will discuss the 5 most common
Resources: Certain investments have certain requirements.
Horizon: Refers to the planned life of the investment. How long
will you have the investment.
Liquidity: How fast can you sell the investment to get cash?
Taxes: Different types are taxed differently.
Unique Circumstances: Almost everyone will have some special or
unique requirements oropportunities. For example, some companies
will match certain types of investments.
Strategies and Policies: Once the IPS is in place, the investor
must determine the appropriate strategies to achiev
the stated objective. Need to address 4 key areas when they
devise their initial strategy.
o Investment management: Who manages the investment. Some will
manage all decisions, others none.
o Market Timing: Buying and selling in anticipation of the
overall direction of the market. Some will move
money to try to get short term gains. Others are less active.
But it can be difficult to time the market.
o Asset Allocation: The distribution of investment funds among
broad classes of assets. How much in stocks
and how much in bonds. A rule of thumb is your equity percentage
should be equal to your age subtracted f
100. So a 22 year old would 100-22=78 have 78% in stocks.
o Security Selection: Selection of specific securities within a
particular class. For example, you might decide
that you want 30% of your money in small stocks. That is an
asset decision but then you must decide whatstocks.
Security Analysis: Investigating particular securities within a
broad class in an attempt to identify
superior performers.
Security selection vs Asset Allocation: A useful way to
distinguish asset allocation from security
selection is to note that asset allocation is a macro-level
activity. That is, the focus is on whole marke
or classes of assets. Security Selection is a much more
micro-level activity The focus of security
selection is on individual securities.
Strategy I: We actively move money b/t asset classes based on
our beliefs and expectations about
future performance. In addition, we try to pick the best
performers in each class. This is a full active
strategy.
Strategy II: We actively vary our holdings by class, but we dont
try to choose particular securities
within each class. With this strategy, we might move back and
forth between short term government
bonds and small stocks in an attempt to time the market.
Strategy III: We do not vary our asset allocations, but we do
select individual securities. A diehard
stock picker would fall into this category. Such an investor
holds 100% stocks and concentrates sole
on buying and selling individual companies.
Strategy IV: is a fully passive strategy. In this strategy, we
seldom change asset allocations orattempt to choose the likely best
performers from a set of individual securities.
Investment Professionals: Important considerations that you need
to take into account before you actually begin
o Choosing a broker/advisor: First step in opening an account is
choosing a broker. Brokers are traditionall
divided into three groups: full service, discount, and deep
discount.
Deep Discount Broker: Essentially the only services provided are
account maintenance and order
executionthat is buying and selling.
Full Service Broker: Will provide investment advice regarding
the types of securities and investmen
strategies that might be appropriate for you to consider.
Discount Broker: fall somewhere in the middle, offering more
investment counseling than the deep
discount and lower commissions or fees that full service.
o
Online Brokers: With an online broker, you place buy and sell
orders over the internet.
Asset
Allocation
Secutity Selection
Active Passive
Active I II
Passive III IV
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o Investor Protection:
The Federal Deposit Insurance Corporation: FDIC, protects money
deposed into bank accounts
The FDIC does not insure stocks, bonds, mutual funds,, or other
investments offered by banks, thrift
institutions, and brokerage firmseven those calling themselves
investment banks.
Investment Fraud: Suppose someone swindles you by selling you
shares in a fictitious company, o
sells you shares in a real company but doesnt transfer ownership
to you. Both are fraud.
Securities Investor Protection Corporation: Insurance fund
covering investors brokerage accou
with member firms. Almost all brokerage firms operating in the
US are required to be members of th
SIPC. Insures account up to $500,000 in cash and securities, w/
a max $250,000 cash.
Broker Customer Relations: Things to keep in mind when dealing
with a broker. First, any adviceyou receive is not guaranteed.
There is risk involved. Your broker does have a duty to
exercise
reasonable care in formulating recommendations and not recommend
anything grossly unsuitable, b
that is essentially the extent of it. Second your broker works
as your agent and has a legal duty to ac
in your best interest; however, brokerage firms are in the
business of generating commissions. Finall
in the unlikely event of a significant problem, your account
agreement will probably specify very clea
that you must waive your right to sue and /or seek a jury trial.
Instead, you agree that any disputes
be settled by arbitration and that arbitration is final and
binding.
Types of accounts: Multiple kinds:
o Cash account: A brokerage account in which all transactions
are made on a strictly cash basis.
o Margin Account: An account in which, subject to limits,
securities can be bought and sold on credit.
Call Money Rate: The interest rate brokers pay to borrow bank
funds for lending to customer margaccounts. You pay some amount
over the call money rate, called the spread; the exact spread
depen
on your broker and the size of the loan.
Margin: the portion of the value of an investment that is not
borrowed. Margin is usually expressed
a percentage.
o Initial Margin: The minimum margin that must be supplied on a
securities purchase. This is set by the Fed,
however the exchanges and individual brokerage firms may require
higher initial margin amounts.
o Maintenance Margin: The minimum margin that must be present at
all times in a margin account. For
example, the NYSE requires a minimum of 25% mtc margin.
Margin Call: A demand for more funds that occurs when the margin
in an account drops below the
maintenance margin. In some cases, you will be asked to restore
your account to the initial margin
level.o Effects of Margin: Margin is a form of financial
leverage. Any time you borrow money to make an invest, th
impact is to magnify both your gains and losses, hence you use
the term leverage.
o Calculate the Critical Price: (this is the lowest price before
you get a margin call). P*=(Amount
Borrowed/Number of Shares) / (1-Maintenance Margin).
Example: You have a margin loan of $40,000, which you used in
part to buy 1000 shares. The mtc
margin is 37.5%. What is the critical stock price?
(40,000/1000)/(1-.375)= 40/.625 = $64.
Annualizing Returns on a Margin Purchase: Things get a little
more complicated when we consider holding perio
differ from a year on a margin purchase.
o Example: You have a call money rate of 9% and pay a spread of
2% over that. You buy 1000 shares at $6
per share, but only put up half the money. In 3 months its
selling for $63/share and you sell. Whats the
annualized returns? ANSWER: You invested $60,000 half of which
is borrowed. In 3 months you repay:Amount repaid = Amount Borrowed
x (1+Interest rate year) `t, where T is the fraction of a year. In
this
example its 3months/12 = .25. So Amount Repaid = 30,000 x (1 +
.11)`.25. = 30,000 x 1.02643, =
$30,792.90. So when you sell the stock you get $63,000 of which
$30,792.90 is used to pay off the loan
leaving you with $32,207.10. You invested 30,000 your gain is
$2,207.1 and your percent return is
2,207.10/30,000 = 7.36%. and since there are 4 periods in the
year, your annual return is 7.36x4=32.85%
o Hypothecation and street name registration:
Hypothecation: Pledging securities as collateral against a
loan.
Street Name Registration: An arrangement under which a broker is
the registered owner of a
security
o Retirement account:
Company Sponsored Plans: 401k , etc.
