INVESTING & THE STOCK MARKETSChapter 11

INVESTING & FREE ENTERPRISE Investing is essential to the free

enterprise system. It promotes economic growth and

contributes to a nation’s wealth. – HOW?

People deposit money into a savings account and the bank lends this money to businesses.

Businesses can then increase production, which leads to expansion and growth.

FINANCIAL SYSTEMS

Financial systems are established in an economy so investments can take place.

When people save money they are really loaning it to other people. Savers receive a document, such as a passbook

or a bond certificate, that confirms their purchase or deposit.

These documents represent the claims, or financial assets, of the borrower.

FINANCIAL INTERMEDIARIES Financial intermediaries, including banks and

other financial institutions, accept funds from savers to make loans to investors.

SHARING RISKS

Dealing with financial intermediaries

offers three advantages: Sharing risk Providing information Providing liquidity

Sharing risk Don’t put all your eggs in one basket! Diversification allows you to spread out your investments so

that you don’t put all of your money into one single investment. Sharing risk helps ward against losing everything on a bad

investment.

TYPES OF RISK Investors must weigh the risks of

investment against the potential rate of return on their investment. How does diversification lessen the risks

described in the chart?

RETURN AND RISKTHE HIGHER THE RISK, THE HIGHER THE POTENTIAL RETURN! The safer the

investment, the lower the return.

Whenever people evaluate their potential investments, they must balance the risks involved with the rewards they expect to gain.

Some investments, like CDs, are very safe since they are gov’t- insured

Investing in a new business is far riskier, but … if it’s a success, the return could be very big.

INVESTMENT ALTERNATIVES• BONDS = a way to save

$ and earn interest• Businesses and governments

borrow $ through issuing of bonds

• A bond is an IOU• Investor “loans” $ to

corporation/government, holds bond until maturity date, then gets paid back at par value

• Just like any loan, the borrower pays interest – the coupon rate - to the lender – usually via a coupon every 6 months

• U.S. savings bonds paid differently – all at end.

• Bond ratings: Standard & Poor’s, Moody’s– Higher the bond rating, the lower the

interest rate it will pay

• Risk? Liquidity? Return?

Corporate Bonds

U.S. Savings Bonds

MunicipalBonds

• Certificates of Deposit (CDs)– Loans from investors to banks– Investors can choose maturity date

• Usually 6 months, two years, three years, etc.• Can deposit as little as $100

– Severe $ penalties for early withdrawal– Risk? Liquidity? Return?

• IRAs – Individual Retirement Accounts– Way to save for retirement– Set aside $3000/year – no taxes on this income

so puts off paying taxes until worker is retired (& then in a lower tax bracket)

– High $ penalties if cashed in early– Risk? Liquidity? Return?

INVESTMENT ALTERNATIVES

INVESTMENT ALTERNATIVES• A professionally managed type of

collective investment scheme that pools money from many investors to buy securities (stocks, bonds, etc.)

• Have a staff of analysts• Investors like them because:

– Gives them a diversified portfolio

– Experts are keeping up with the investments

– They pay dividends– Slow to change in value– Risk? Liquidity? Return?

WHAT ARE YOU REALLY GETTING WHEN YOU BUY A STOCK?

Part ownership… but no real control

A certain amount of risk Faith in the financial

reporting Fairly liquid investment Only a paper value until

sold

What to look for when picking stocks…

• Company information• News articles• Numbers: dividends; charts –

price/volume trends• Analyst reports• Annual/quarterly reports• Insider buying/selling

PREFERRED STOCK• Bought like any stock• Dividends, if any, go to

preferred shareholders first and are “guaranteed”

• Generally has no voting rights• Ahead of common stock for

liquidated assets in bankruptcy

TYPES OF STOCK

COMMON STOCK• Most widely held type of stock• Confers voting rights: 1 share = 1

vote• May attend company annual meeting• May raise concerns to Board of

Directors• May receive dividends• Last in line for assets in a bankruptcy

““WALL STREET” ...WALL STREET” ...$ Refers in general to the markets in

the U.S. for stock trading$ It is where financial trading began in

colonial America.$ It is home to our oldest stock

exchange, the New York Stock Exchange

WHAT IS AN EXCHANGE?

$ It simply refers to the meeting place - physical or virtual - for buyers and sellers of stocks & bonds (a/k/a “securities”)

$ In a stock exchange, representatives of buyers & sellers meet to trade on behalf of their customers.

$ These exchanges function as auction markets.

MAJOR U.S. STOCK MAJOR U.S. STOCK EXCHANGES:EXCHANGES:

$ New York Stock Exchange - NYSENew York Stock Exchange - NYSE$ is the oldest & largest in U.S.is the oldest & largest in U.S.$ is located at 11 Wall Street, NY, NYis located at 11 Wall Street, NY, NY$ ““Blue Chip” stocks listed hereBlue Chip” stocks listed here

$ American Stock Exchange - AMEXAmerican Stock Exchange - AMEX$ younger companies are listed hereyounger companies are listed here$ lots of energy companies listedlots of energy companies listed$ located in NY also -- just a few blocks located in NY also -- just a few blocks

from NYSEfrom NYSE

The Trading Floor of the New York Stock Exchange

How is this exchange different?

$ NASDAQ - National Association of Securities Dealers Automated Quotations$ is an electronic market -- no floor

trading / phone & computer only$ is our second largest market$ is based in Washington, D.C.$ Primary focus -technology stocks

Securities & Exchange Securities & Exchange CommissionCommission

$ The SECThe SEC$ Government agency responsible for Government agency responsible for

overseeing the stock marketoverseeing the stock market$ Established after the 1929 CrashEstablished after the 1929 Crash$ Function is to make sure investors Function is to make sure investors

are informed & to help prevent are informed & to help prevent cheating in stock transactionscheating in stock transactions

$ Prospectus required before stock Prospectus required before stock purchasespurchases

THE “DOW”

$ Is the Dow Jones Industrial Average$ Takes the average of 30 stocks to

determine whether the market traded up or down for the day (compared to a previous average)

$ Serves as a “thermometer” & gives a quick reading of the market’s temperature

• It is compiled daily by Dow Jones & Company (owner of the Wall Street Journal)

• Investors use the Dow to compare the performance of their stocks

• Dow was originally 12 stocks. The only stock in the original 12 Dow stocks that is in the 30 Dow stocks today is GE

The 30 Stocks of the Dow Jones Industrial Average

THE IMPACT OF 9-11 ON THE DOW

What’s the difference between a Bull and a Bear Market?

Bull market – prices climbing over an extended period of time

Bear market – prices falling over an extended period of time

Margin buying – you believe a stock will rise

Other Ways of Making Money in the Market

Buying with borrowed money

Buying on margin works like this:

– You could buy stock with only a 10% down payment (1,000 shares, $10/share = total cost of $10,000 but you just put 10%/$1,000 down)

– You borrow the remaining 90% ($9,000) from the stockbroker

– Then, when the price goes up ($20/share for ex., you sell it ($20,000) & pay off broker ($9,000) and keep the remaining profit ($11,000)

– BUT, when stock values start going down, everybody tries to sell & prices keep plummeting

– Broker then sells off your stock (for ex., at $5 per share- $5,000) & gets less than what you owe him

– Now you have no stock, and still owe $4,000 on your loan to the broker

– So … what type of market do you need if you want to use margin buying?

Short selling – you believe a stock price will fall

Other Ways of Making Money in the Market:

Selling with borrowed stock –

Borrow stock, not $, then sell to “cover” the stock you borrowed.

Short selling works like this:– You borrow stock from the broker (1000

shares) – this is what you have to return to him…1000 shares

– You sell the borrowed stock – for ex., at $10 per share – and you are expecting the stock value to continue to go down (you now have $10,000)

– When the prices do go down (let’s say to $5 per share), you now “cover” your stock loan and buy 1000 shares to repay the stock to the broker

– You made a $5,000 profit off stock you never owned!

– BUT, when stock prices start going up, you have a problem

– If you had to buy back the stock at $12 for example, your cost would be $12,000 and you would be $2,000 down on this transaction

Should you diversify your stocks?

How lucky do you feel?

TIP: Do diversify your portfolio!Buy different stocks so that losses in onecan be balanced by gains elsewhere.

Had been dubbed “America’s Most Innovative Company” but in 2001 it died out in a bankruptcy wrapped up in accounting fraud, criminal charges, and the destruction of employee investments and retirement savings.

• THE TIME VALUE OF MONEY HAS A SIGNIFICANT IMPACT ON SAVINGS & INVESTMENT GROWTH:– The more time you

have to invest,– The more money you

have to invest,– & the higher the rate

of interest you can earn

• EQUALS A GREATER RETURN ON YOUR $

SAVING & COMPOUND INTERESTSAVING & COMPOUND INTEREST

REMEMBER: THE RETURNRETURN IS THE AMOUNT EARNED ON ONE’S SAVINGS/INVESTMENTS

• COMPOUNDINGCOMPOUNDING provides even more incentive to invest early.

• COMPOUND COMPOUND INTERESTINTEREST = the $ earned on your original deposit AND the interest payments you have received on that deposit in the past

The Rule of 72

• An easy rule to determine how much your savings or investments can grow with compound interest.

• Just divide the interest rate into 72. The result tells you how long it will take for your money to double without further savings.

• For example, you have $10,000, which is earning 6% interest (after tax). 72 divided by 6 = 12.

• Every 12 years your $10,000 will double, so:– After 12 years you have $20,000 – After 24 years you have $40,000 – After 36 years you have $80,000

Do I Have A Deal for You!Do I Have A Deal for You! You go in for a summer job interview. The boss offers to

pay you $50 a day for a 5-day, 10-week positionOR You can earn only one cent on the first day but have your

daily wage doubled every additional day you work. Which option would you take?

Option A – you would earn $2,500 if you work all 50 days

Option B – if you took this offer and worked only HALF the summer, you would earn $167,772.16……by the 30th day you would have over $5,000,000!!!

The Time Value of $• DOES IT REALLY MATTER WHEN YOU

START SAVING?

• Jim and Mary are both 22. They both want to save $1000 a year for retirement.– Mary starts saving at age 22 and saves

for 20 years, until she is 42. Mary then quits and leaves her savings to compound.

– Jim starts 10 years later at 32 and saves for 33 years until age 65.

• Both earn 4% on their savings every year.

• Who do you think has more money at age 65?

• Mary has built a fund of $76,327 at age 65.• At age 65, Jim’s fund is $68,855,• Jim put more money into his savings but

because Mary started early and gave her savings more time to compound, Jim was not able to catch up.

More on the time value ….The sooner you start to save, the greater the benefit of compound interest!

• In this example, two different individuals--Darryl and Cheryl, each 22 years old--have an extra $2,000 a year to invest or spend as they choose. Darryl opens an Individual Retirement Account (IRA) to start saving. Cheryl chooses to spend her $2,000.

• In this example, Darryl's IRA earns 12% per year. Darryl saves $2,000 per year for 6 years, then never puts another cent into his IRA. Darryl's total investment is $12,000.

• Cheryl spends her $2,000 per year for six years. At age 28, she starts investing $2,000 per year until she is 65 years old (37 years). Cheryl's total investment is $74,000 . Cheryl earns the same 12% interest per year that Darryl does.

• Because she lost some of the time value of money, Cheryl had to invest an extra 31 years & an extra $62,000 to get to the same stage by retirement age.

Age Darryl Cheryl

22 $2,240 $0

23 4,509 0

24 7,050 0

25 9,896 0

26 13,083 0

27 16,653 0

28 18,652 2,240

29 20,890 4,509

30 23,397 7,050

35 41,233 25,130

40 72,667 56,993

45 128,064 113,147

50 225,692 212,598

55 397,746 386,516

60 700,965 693,879

65 1,235,339 1,235,557