Chapter 1: A Brief History of Risk and Return

Module 1 Key Points

Chapter 1: A Brief History of Risk and Return

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  1. Returns

This chapter uses financial market history to provide information about risk and return. In general, two key observations emerge:

  • There is a reward for bearing risk and, on average, the reward has been considerable.
  • Greater rewards are accompanied by greater risks.

The important point is that risk and return are always linked together.

A. Dollar Returns

Total dollar return: the return on an investment measured in dollars that accounts for all cash flows and capital gains or losses.

When you buy an asset, your gain or loss is called the return on your investment. This return is made up of two components:

  • The cash you receive while you own the asset (interest or dividends), and
  • The change in value of the asset, the capital gain or loss.

The total dollar return is the sum of the cash received and the capital gain or loss on the investment. Whether you sell the stock or not, this is a real gain because you had the opportunity to sell the stock at any time.

  1. Percentage Returns

Total percent returns: the return on an investment measured as a percentage of the original investment that accounts for all cash flows and capital gains or losses

When you calculate percent returns, your investment doesn’t depend on how much you invested. Percent returns tell you how much you receive for every dollar invested. There are two components of the return:

  • Dividend yield, the current dividend divided by the beginning price
  • Capital gains yield, the change in price divided by the beginning price
  1. A Note on Annualizing Returns

To compare investments, we need to “annualize” the returns, which we refer to as the Effective Annual Return (or EAR).

1 + EAR = (1 + holding period return)m

Where is the number of holding periods in a year.

  1. The Historical Record

The year-to-year historical rates of return on five important categories of investments are analyzed in this section. These categories are:

  • Large-company stocks, which is based on the Standard & Poor’s 500 index (S&P 500).
  • Small-company stocks, where “small” corresponds to the smallest 20% of the companies listed on the New York Stock Exchange, as measured by the market value of outstanding stock.
  • Long-term corporate bonds, which is a portfolio of high-quality bonds with 20 years to maturity.
  • Long-term U.S. government bonds, which is a portfolio of U.S. government bonds with 20 years to maturity.
  • U.S. Treasury bills (T-bills) with a three-month life.

The annual percentage changes in the Consumer Price Index (CPI) are also calculated as a comparison to consumer price goods inflation.

  1. A First Look

When we examine the returns on these categories of investments from 1926 through 2009, we see that the small-company investment grew from $1 to $12,971.38, the larger common stock portfolio to $2,382.68, the long-term government bonds to $75.33, and T-bills to $22.33. Inflation caused the price of a good to grow from $1 to $12.06 over the 84 years. An obvious question resulting from examining this graph would be, “Why would anyone invest in anything other than small-company stocks?” The answer lies in the higher volatility of the small- company stocks. The topic will be discussed later in this chapter.

  1. A Longer Range Look

When we look at a longer term, back to 1802, we see that the return from investing in stocks is much higher than investing in bonds or gold. Over this 207-year period, one dollar invested in stocks grew to an astounding $10.7 million, whereas bonds only returned $24,385, and gold (until the past few years) has simply kept up with inflation. The moral is, “Start investing early.”

  1. A Closer Look

As you examine the bar graphs you can observe that the return on stocks, especially small-company stocks, was much more variable than bonds or T-bills.

The returns on T-bills were much more predictable than stocks. Although the largest one-year return was 143% for small-company stocks and 53% for large-company stocks, the largest T-bill return was only 15%. The largest historical return for long-term government bonds was 40.35%, which occurred in 1982.

  1. 2008: The Bear Growled and Investors Howled

The S&P500 index plunged -37 percent in 2008, which is behind only 1931 at -43 percent. Moreover, there were 18 days during 2008 on which the value of the S&P changed by more than 5 percent. From 1956 to 2007 there were only 17 such days.

  1. Average Returns: The First Lesson

This section provides simple measures to accurately summarize and describe all of these numbers, starting with calculating average returns.

  1. Calculating Average Returns

The simplest way to calculate average returns is to add up the annual returns and divide by the number of years. This will provide the historical average. So, the average return for the large-company stocks over the 84 years is 11.7%.

  1. Average Returns: The Historical Record

Table 1.2 also shows that small-company stocks had an average return of 17.7%, government bonds returned 5.9% on average, and T-bills only returned 3.8%. Note that the return on T-bills is just slightly more than the inflation rate of 3.1%.

  1. Risk Premiums

Risk-free rate: the rate of return on a riskless investment.

Risk premium: the extra return on a risk asset over the risk-free rate.

The rate of return on T-bills is essentially risk free because there is no risk of default. So we will use T-bills as a proxy for the risk-free rate, our investing

benchmark. If we consider T-bills as risk-free investing and investing in stocks as risky investing, the difference between these two returns would be the risk premium for investing in stocks. This is the additional return we receive for investing in the risky asset, or the reward for bearing risk.

The U.S. Equity Risk Premium: Historical and International Perspectives: Earlier periods suggest a lower risk premium than recent, while international risk premiums also tend to be slightly lower. Based on evidence and expectations, 7 percent seems to be a reasonable estimate for the risk premium.

  1. The First Lesson

When we calculate the risk premium for large-company stocks (stock return minus the T-bill return) we get 7.9% and for government bonds 2.1%. Of course, the risk premium for T-bills is zero. So we see that risky assets, on average, earn a risk premium, or “there is a reward for bearing risk.” The next question is, “Why is there a difference in the risk premiums?” This is addressed in the next section and relates to the variability in returns.

  1. Return Variability: The Second Lesson
  2. Frequency Distributions and Variability

Variance: a common measure of volatility.

Standard deviation: the square root of the variance.

Variance and standard deviation provide a measure of return volatility or how much the actual return differs from this average in a typical year. This is the same variance and standard deviation discussed in statistics courses.

  1. The Historical Variance and Standard Deviation

The variance measures the average squared difference between the actual returns and the average return. The larger this number, the more the actual

returns differ from the average return. Note how the stocks have a much larger standard deviation than the bonds and were therefore more volatile.

Another method to calculate the variance is to structure it in the form of a table where each step is a separate column. This is illustrated below using the data in the text.

For 1926-1930, the average return for large-company stocks (as represented by the S&P 500) = (13.75+35.70+45.08-8.80-25.13)/5 = 60.60/5 = 12.12%

RNRN – RA(RN – RA)2
13.75%13.75 -12.12 = 1.63(1.63)2=2.66
35.70%35.70 -12.12= 23.58(23.58)2=556.02
45.08%45.08 -12.12= 32.96(32.96)2=1,086.38
-8.80%-8.80 -12.12 = -20.92(-20.92)2=437.65
-25.13%-25.13 -12.12 = -37.25(-37.25)2=1,387.56
Sum of squares =3,470.24
(RN – RA)2 / (N-1) =3,470.24/(5-1) =867.56Variance
Square root =29.45%Standard deviation


Note the difference between using N-1 and N as the divisor when calculating variance and standard deviation. You use N when you have the entire population, as opposed to N-1 when you have a sample of the population.

Also note the units in which variance and standard deviation are expressed: variance is percent squared, whereas standard deviation is percent.

This example calculates variance and standard deviation using historical data. When expected futures values are used, there is another method that must employ probabilities. This method will be discussed in a later chapter.

  1. The Historical Record

The standard deviation for the large-company stock portfolio is more than six times the standard deviation for the T-bill portfolio. Also notice that the distribution is approximately normal. This allows us to use the fact that plus or minus one standard deviation from the mean return gives us the range of returns that would result 2/3 of the time. If we take plus or minus two standard deviations from the mean, there is a 95% probability that our investment will be within this range of returns.

  1. Normal Distribution

Like most statistical concepts, students will struggle remembering the concept of a normal distribution. In our experience, this is mostly because they are unsure of their understanding—not that they have not “seen” the material before.

For many different random events in nature, a particular frequency distribution, the normal distribution (or bell curve) is useful for describing the probability of ending up in a given range. For example, the idea behind “grading on a curve” comes from the fact that exam scores often resemble a bell curve.

Figure 1.10 illustrates a normal distribution and its distinctive bell shape. As you can see, this distribution has a much cleaner appearance than the actual return distributions illustrated in Figure 1.8. Even so, like the normal distribution, the actual distributions do appear to be at least roughly mound shaped and symmetric. When this is true, the normal distribution is often a very good approximation.

Also, you will have to remind students that the distributions in Figure 1.9 are based on only 84 yearly observations, while Figure 1.10 is, in principle, based on an infinite number. So, if we had been able to observe returns for, say, 1,000 years, we might have filled in a lot of the irregularities and ended up with a much smoother picture. For our purposes, it is enough to observe that the returns are at least roughly normally distributed.

The usefulness of the normal distribution stems from the fact that it is completely described by the average and the standard deviation. If you have these two numbers, then there is nothing else to know. For example, with a normal distribution, the probability that we end up within one standard deviation of the average is about 2/3. The probability that we end up within two standard deviations is about 95 percent. Finally, the probability of being more than three standard deviations away from the average is less than 1 percent.

  1. The Second Lesson

Observing that there is variability in returns from year-to-year, we see that there is a significant chance of a large change in value in the returns. So the second lesson is: The greater the potential reward, the greater the risk.

  1. More on Average Returns
  1. Arithmetic versus Geometric Averages

The geometric average return answers the question: “What was your average compound return per year over a particular period?”

The arithmetic average return answers the question: “What was your return in an average year over a particular period?”

  1. Calculating Geometric Average Returns

Let us use data from the example above to calculate an arithmetic average and a geometric average:

RN1+RN1+RN,1 x 1+RN,2 x …
13.75%1.13751.1375
35.70%1.35701.5436
45.08%1.45082.2394
-8.80%0.91202.0424
-25.13%0.74871.5291
Sum:60.60Raised to 5th
Power:1.08865
ArithmeticGeometric
Average:12.12%Average:8.87%


  1. Arithmetic Average Return or Geometric Average Return?

Two points are worth stressing:

First, generally, when one sees a discussion of “average returns,” the return in question is an arithmetic return.

Second, there is a nettlesome problem concerning forecasting future returns using estimates of arithmetic and geometric returns. The problem is: arithmetic average returns are probably too high for longer periods, and geometric average returns are probably too low for shorter periods. Fortunately, Blume’s formula provides a way to weight arithmetic and geometric averages for a T-year average return forecast using arithmetic and geometric averages which have been calculated for an N-year period (T cannot exceed N).

Blume’s formula is:

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As is readily apparent from this formula, as T (the length of time of the forecast) increases, the geometric average receives a higher weight relative to the arithmetic average. That is, if N = T, the arithmetic average receives no weight,

and the resulting forecast stems entirely from the geometric average. If T = 1, then the geometric average receives a zero weight. In this case, the resulting forecast comes only from the arithmetic average.

  1. Dollar-Weighted Average Returns

If an investor adds money to or subtracts money from an account, his actual return will likely be different than either the arithmetic or geometric average. The dollar weighted return (or internal rate of return, IRR) captures the impact of cash flows, giving the average compound rate of return earned per year.

  1. Risk and Return
  2. The Risk-Return Trade-off

If we are unwilling to take on any risk, but we are willing to forego the use of our money for a while, then we can earn the risk-free rate. We can think of this as the time value of money. If we are willing to bear risk, then we can expect to earn a risk premium, on average. We can think of these two factors as the “wait” component and the “worry” component.

Notice that the risk premium is not guaranteed, it is “on average.” Risky investments by their very nature of being risky do not always pay more than risk-free investments. Also, only those risks that are unavoidable are compensated by the risk premium. There is no reward for bearing avoidable risk.

  1. A Look Ahead

The remainder of the text focuses on financial assets only: stocks, bonds, options and futures. Remember that to understand the potential reward from an investment, you must understand the risk involved.

Chapter 2: The Investment Process

  1. The Investment Process

Investing is simply deferred compensation. We invest to have more to spend later. So investing and saving are very similar.

The first step in the investment process is to form an Investment Policy Statement (IPS). This document serves as the roadmap for your investments, providing details on objectives and constraints.

A. Objectives: Risk and Return

Investors must decide how much risk they are willing to bear. Since most investors are risk averse, they want to be compensated fairly for any risk they take on. Determining their risk tolerance will help investors to define the available investments and strategies.

B. Investor Constraints

An investor’s investment strategy is affected by several constraints, including resources, horizon, liquidity, taxes, and special circumstances.

  • Resources relate to how much the investor has to invest.
  • The investment horizon refers to the planned life of the investment, which relates to when the money is needed. The investment horizon will help determine the riskiness of the investment.
  • Liquidity refers to how easy it is to sell an asset without much loss in value. If an investor needs to sell an investment quickly, its liquidity becomes very important.
  • The relevant return on an investment is its after-tax return. Since different types of investments are taxed differently, an investor must be concerned with the tax effects. For high tax bracket individuals, tax deferral or avoidance may be very important. For example, these investors may be more interested in tax exempt investments, IRAs, 401(k)s, or long term capital gains.
  • There are an endless number of special circumstances that may affect investment decisions. For example: employer investment matches, number of dependents, politically or socially conscious investors, or corporate insiders.
  1. Strategies and Policies

Investment Management: Hiring a professional manager to manage your investments.

Market Timing:Buying and selling in anticipation of the overall direction of the market.

Asset Allocation: the distribution of investment funds among broad classes of assets.

Security Selection: Selection of specific securities within a particular class.

When formulating an investment strategy, an investor must consider investment management, market timing, asset allocation, and security selection.

  • There are pros and cons to using a professional investment manager. Even though an investment manager charges management fees, there still may be savings in commissions, fees, and time when using a manager.
  • An investor that practices market timing buys and sells investments in an attempt to actively time the market movements. A passive strategy makes no attempt to time the market. Later, the authors discuss how difficult it is to time the market.
  • When forming an investment strategy, an investor must allocate investments between different asset classes, including large cap stocks, small cap stocks,

international stocks, bonds, etc. This allocation will determine the investor’s expected risk and return.

  • After deciding on asset classes, an investor must select specific securities for investment. Investigating specific securities within a broad asset class to find superior performers is called security analysis. This can be active (select specific securities) or passive (select mutual funds).

We can think of asset allocation as a macro activity, and security selection as a micro activity. An investor can vary his/her strategy between active and passive asset allocation, and active and passive security selection for a full range of involvement and risk/return profiles. About 90% of a portfolio’s return is driven by allocation, so it is, by far, the more important activity.

  1. Investment Professionals

To get started, simply set up a trading account with a broker. You will supply basic information and sign a customer’s agreement. You then give your broker a check and instructions on how to invest your money. When you purchase (or sell) a stock you will pay a commission to the broker and you will instruct the broker whether to hold the shares or deliver them to you.

  1. Choosing a Broker / Advisor

To open an account you must choose a broker. There are typically three groups: Full service brokers, discount brokers, and deep-discount brokers.

Full service brokers provide many services, including investment advice, research services, account management, and personal service. In addition to telephone and web access, you can usually visit full service brokerage offices. Full service brokers charge the highest fees. These professionals have generally moved to an advisory based relationship, where you pay a fee (say 1%) based on asset value. This covers all costs associated with advice and trading.

Discount brokers typically provide more services than the deep discount brokers but fewer than the full service brokers. Their fee is usually in-between the fees of the full service and the deep discount brokers.


A deep discount broker provides minimal services, normally just account maintenance and order execution (buying and selling). You usually contact the deep discount broker on the telephone or over the web. The brokerage commissions are lowest for deep discount brokers.

With increased competition, the lines are beginning to blur between the three types of brokers. Discount and deep discount brokers are beginning to offer more services and full service brokers are offering discounts for some types of accounts.

  1. Online Brokers

The most dramatic change in the brokerage industry is the growth of online or web-based brokers. With online brokers you place orders over the Internet using a web browser (Netscape or Internet Explorer). Before 1995, online trading barely existed, but currently, growth in online trading is exponential.
The commissions are usually much lower, generally less than $20 per trade and sometimes as low as $9 per trade. Online brokers are able to charge less because it is less expensive and more efficient to handle orders electronically. Services provided vary, usually related to cost, from “no-frills” to many services, including: research, account management, banking services, credit cards, etc. Online brokerages will probably become the dominant form of trading because of the low commissions and convenience.

  1. Investor Protection

Federal Deposit Insurance Corporation (FDIC): Government agency that protects money deposited into bank accounts (up to $100,000 per account). It was created in 1933 and since the start of FDIC insurance on January 1, 1934, no depositor has lost insured funds due to bank failure.

Investment Fraud: Two examples include someone selling you shares in a fictitious company or someone selling you shares in a real company without transferring ownership to you. Losses due to investment fraud in the U.S. range from $10 to $40 billion per year. There is no “insurance” against investment fraud in the U.S., although there are state and federal agencies in place to help investor deal with investment fraud.

Securities Investors Protection Corporation (SIPC): Insurance fund covering investors’ brokerage accounts with member firms.

The SIPC was created in 1970 and is not a government agency. The SIPC insures your account up to $500,000 in cash and securities, with a $100,000 cash maximum. Because of government regulation, most brokerage firms belong to the SIPC. Note that the SIPC only ensures that you will receive the value of the cash and securities held by the broker in the event of fraud or failure. It does not guarantee against losing money on your investment.

  1. Broker-Customer Relations

You must remember that advice from a broker is not guaranteed—you purchase securities at your own risk. Your broker is your agent and is legally required to work in your best interest. But you still need to check your account statement and notify your broker in the event of any problems or irregularities, such as account churning. If there is a significant problem, your account agreement specifies that

you waive your right to sue and you must settle the dispute by binding arbitration. This is not a legal proceeding and the panel is appointed by a self-regulatory body of the securities industry. The findings normally cannot be appealed.

  1. Types of Accounts

The account agreement has important provisions about the types of trades that can be made, who can make them, and whether credit can be extended.

  1. Cash Accounts

Cash Account: A brokerage account in which all transactions are made on a cash basis. Securities can only be purchased if there are sufficient funds in the account.

  1. Margin Accounts

Margin Account: A brokerage account in which securities can be bought and sold on credit.

Call Money Rate: The interest rate that is charged on funds borrowed in a margin account. A spread is also charged on the loan above the call money rate.

Margin: The portion of the value of the investment that is not borrowed.

Initial Margin: The minimum margin that must be supplied on a securities purchase.

Maintenance Margin: The minimum margin that must be present at all times in a margin account. Maintenance margin is sometimes called the “house” margin requirement.

Margin Call: A demand for more funds that occurs when the margin in an account drops below the maintenance margin.

Under a margin account you are purchasing securities on credit using money loaned by the broker. This is a margin purchase and the interest rate is the call money rate plus a spread. When you purchase on credit, you supply some of the money—the margin—and the rest is borrowed. You calculate the margin as a percentage of the total investment. For example, if you supply $7,000 to purchase $10,000 in securities, your margin is 70%.

The minimum margin that you must supply when you first purchase the security is the initial margin. The minimum is set by the Federal Reserve, although

brokerage firms may require more. Since 1974, the minimum has been 50%. So, for example, if you purchase $50,000 in securities, you must supply $25,000 of

the investment. Note that this is for stocks; there is little initial margin for bonds, and margin is not allowed for some other types of securities.

Brokerage firms and the exchanges also require maintenance margin, the minimum amount that must always be present in the account. The NYSE requires 25% and a typical maintenance margin is 30%. If your margin falls below 30%, you are subject to a margin call from your broker. This is a demand by your broker to bring the account back up to the 30% level, pay off part of the loan, or sell enough securities to maintain the 30%. If you don’t comply, your securities may be sold to repay the loan, with remaining amounts credited to your account.

Why do investors use margin for financial leverage? When you borrow for an investment, you magnify your gains or losses. For example, assume you have $10,000 to invest in a $100 stock. You can purchase 100 shares for cash or 200 shares using a margin loan. Assume the stock price goes to $120. You have now made 20% on your cash investment, but 40% on your margin investment. But if the price goes down to $80, you have lost 20% on your cash investment and lost 40% on your margin investment. The joys of leverage!

  1. Annualizing Returns on a Margin Purchase

In Chapter 1, we talked about the need to compute percentage returns, but, so far, we’ve only considered annual returns. Of course, the actual length of time you own an investment will almost never be exactly a year. To compare investments, however, we will usually need to express returns on a per-year or “annualized” basis, so we need to do a little bit more work.

For example, suppose you bought 200 shares of Cisco at a price of $80 per share. In three months, you sell your stock for $85. You didn’t receive any dividends. What is your return for the three months? What is your annualized return? In this case, we say that your holding period, which is the length of time you own the stock, is three months. From our discussion in Chapter 1, with a zero dividend, you know that the percentage return can be calculated as:

Percentage return = (Pt+1 – Pt)/Pt = ($85− $80)/$80 = .0625 = 6.25%

This 6.25 percent is your return for the three-month holding period, but what does this return amount to on a per-year basis? To find out, we need to convert this to an annualized return, meaning a return expressed on a per-year basis. Such a return is often called an effective annual return, or EAR for short.

The general formula is:

1 + EAR = (1 + holding period percentage return)m

where m is the number of holding periods in a year.

In this example, the holding period percentage return is 6.25 percent, or .0625. The holding period is three months, so there are four (12 months/3 months) periods in a year. The annualized return, or EAR, is thus:

1 + EAR = (1 + holding period percentage return)m

= (1 + .0625)4

= 1.2744

So, your annualized return is 27.44 percent.

D. Hypothecation and Street Name Registration

Hypothecation: Pledging securities as collateral against a loan.

Street Name: An arrangement where the broker is the registered owner of the security.

As part of your margin account agreement you must agree to hypothecation of your securities and street name registration. Hypothecation allows the broker to hold your securities as collateral against your loan. This is essential in the case of a margin call. Since the security is held in street name, the broker is the registered owner and is allowed to sell the security in order to meet a margin call. Advantages of a street name account include: protection against theft or loss of the security, dividends or interest payments are automatically credited to your account and the broker provides regular account statements, which are beneficial for record-keeping and tax purposes. A disadvantage arises when you want to sell the security through another broker—you must request the stock certificate be sent to the new broker. There will also normally be a charge for the service of issuing stock certificates, a typical amount being in the range of $25.

  1. Retirement Accounts

Although tax laws change quickly (and it is important to stress this), there are essentially two types of individual retirement savings accounts:

  • A “Roth” Individual Retirement Account (IRA): Here, you invest after-tax dollars, and pay no taxes at all when you take the money out later. That is, you pay no taxes on dividends, interest, or capital gains.
  • “Tax-Deferred” 401(k) plans: Here you invest “pre-tax” dollars, but must pay taxes on dividends, interest, and capital gains when money is withdrawn from the account.

So, either: 1) you pay taxes today, but not later, or 2) you pay taxes later, but not today.

With 401(k) and 403(b) plans, you generally have a tax-deferred account where you have a menu of investing choices and some type of company matching contribution.

F. Other Account Issues

Advisory Account: An account where the investor pays someone to make the investment decisions on their behalf. All fees and commissions are the responsibility of the investor.

Wrap Account: The investor chooses a money manager and all costs, commissions, and expenses are “wrapped” into one single fee.

Asset Management Accounts: An account that provides complete money management, including check-writing privileges, credit cards, and margin loans. Any uninvested cash is automatically invested to earn interest and the account holder receives detailed statements.

If you want to buy and sell securities, then a brokerage account is almost a requirement. If you don’t want to actively buy and sell securities, but you do want to invest in stocks and bonds, then you can invest in a mutual fund. A mutual fund combines the funds from a large group of investors and the buy/sell decisions are made by the fund manager. Mutual funds will be covered in more detail in Chapter 4.

2.4 Types of Positions

Short Sale: A sale in which the seller does not actually own the security that is sold.

Short Interest: The amount of common stock held in short positions.

  1. Basics of a Short Sale

When an investor buys a stock, the investor is long in the stock. The investor makes money when the price goes up, as in “buy low, sell high.” When an investor sells short or shorts the stock, the investor is selling the stock with the intent of repurchasing it in the future. When the stock is repurchased, the investor is covering the short position. The short investor profits when the price of the stock goes down. They are thinking the reverse of the long investor, as in, “sell high, buy low.”

The stock that is sold in a short sale is borrowed from another investor’s margin account. They agreed to loan the stock when they signed the margin agreement.

The investor that loaned the stock still receives all dividends or distributions and can still sell the stock any time they wish.

  1. Short Sales: Some Details

When you short sell a stock, you borrow the stock from the broker. You incur initial margin, must meet the maintenance margin requirements, and must pay any dividends that are paid during the short position. Important: Even though you have sold the stock, you do not have access to the proceeds from the sale.

Notice that the account balance sheet differs for short sales because the sales price is locked in. In fact, the asset side (left side) of the balance sheet is constant and the total for liabilities and equity (right side) is also constant. The short position varies with the fluctuating stock price and the account equity changes to reflect the difference between the total and the short position. With these changes, the calculation of maintenance margin is similar to a typical margin account.

Short selling is a common practice and generates a high volume of stock sales. This is reflected by short interest, the amount of stock held in short positions. As shown in the text, the level of short interest in major corporations can be in tens of millions of shares.

  1. Short Sale Constraints

The uptick rule prevented shorting stocks except after an uptick. It was eliminated in 2007; however, after the crash of 2008, there is serious discussion of how to reinstate it. Also related to the crash, the SEC banned short selling in financial stocks; however, there is debate over the effectiveness of this ban.

  1. Forming an Investment Portfolio
  1. Some Risk Tolerance Scores

In an administration of the risk tolerance quiz to 10 students, staff, and faculty at a well-known university in St. Louis, the scores range from 27 to 85. The average score for males and females was roughly the same. However, the average score for investors with little to no investment experience is 47 while those with at least some investment experience have an average score of 61. ?

  1. Risk and Return

Risk tolerance is the first thing to assess in evaluating the suitability or an investment strategy.

  1. Investor Constraints

It is important to consider investor constraints in establishing brokerage accounts for investment portfolios.

  1. Strategies and Policies

In investment portfolios, the investor must consider investment management, market timing, security selection and asset allocation.

  1. More on Asset Allocation

Strategic allocation sets the longer term asset allocation, while tactical allocation looks for short-term deviations to the allocation to take advantage of perceived opportunities.

  1. REITs (Real Estate investment Trust(s))

A company that owns income-producing real estate such as apartments, shopping centers, offices, hotels, and warehouses. These can be risky assets because cash flows from the properties are not guaranteed.

Chapter 3: Overview of Security Types

  1. Classifying Securities

This chapter provides an introduction to the different types of securities. In general, three questions are asked:

  • What are the security’s basic nature and its distinguishing characteristics?
  • What are the potential gains and losses?
  • How are prices quoted?


The three basic types of financial assets are: interest-bearing, equities, and derivatives. Some securities are hybrids—they are combinations of the basic types of securities. Financial assets are also referred to as securities and financial instruments.

  1. Interest-Bearing Assets

Interest bearing assets: value of the asset depends on interest rates.

The values of all of these assets depend on interest rates; they are a type of loan, and they are all debt obligations. There are many types of interest-bearing assets, and they range from the simple to the very complex.

  1. Money Market Instruments

Money market instruments: short-term obligations of corporations and governments that mature in one year or less.

Treasury Bills: money market security sold by the U.S. Treasury, on a discount basis, with no possibility of default (risk-free).

Money market instruments are the simplest form of interest-bearing asset. They are IOUs sold by large corporations or governments, and they mature in less than one year. They are usually sold in large denominations and are very liquid.

Treasury bills are the most familiar type of money market instruments. The U.S. Treasury borrows billions of dollars by selling T-bills to the public. They are sold on a discount basis, i.e., sold at a price less than their stated face value. When they mature, the investor receives the full face value, and the difference is the interest earned. The risk of default is very low, so T-bills are essentially risk-free.

  1. Fixed-Income Securities

Fixed income securities: These are longer-term debt obligations (over 12 months) of corporations and governments. These securities make fixed payments according to a preset schedule.

Fixed income securities are issued by corporations and governments: promise to make fixed payments, are debt obligations, and have maturities that are 12 months or longer. They also are known by the terms “note” or “bond.”

Example:

Suppose you purchase a $10,000 face value four-year Treasury note with a 5 percent coupon. The notes pay interest semiannually, so you will receive $500 per year or $250 in two semiannual coupon payments for each of the next four years. At the end of year four you will receive both the last $250 interest payment and the $10,000 face value.

When discussing bond quotations it is important to stress the difference between the coupon rate and the current yield. For the vast majority of bonds the coupon rate does not change. The major use of the coupon rate is to calculate the coupon interest payment. It is also important to remember that bond prices are quoted as a percentage of face value.

3.3 Equities

Equities consist of common stock and preferred stock.

  1. Common Stock

Common stock: This security represents ownership in a corporation. Benefits include cash dividends and potential capital gain in the value of the shares. Neither benefit is guaranteed.

Common stock represents ownership in a corporation. As an owner, you are entitled to a share of any profits paid out by the corporation, and you have the right to vote on important corporate issues. Shareholders receive two benefits from owning common stock: dividends and capital gains. They receive the cash dividends paid by the corporation, although the amount and timing of the dividends are not guaranteed. The dividends are determined by the company’s board of directors, elected by the shareholders. The capital gains accrue from the price of the shares increasing or decreasing in value. Neither of the benefits is guaranteed.

  1. Preferred Stock

Preferred Stock: This security is a hybrid security. The dividends and fixed liquidation value are similar to a fixed income security. The gain or loss from the change in value resembles equity. For tax purposes, preferred is treated as equity.

Preferred stock differs from common in that the dividend is usually fixed (and never changes), preferred shares have a set value upon liquidation of the firm, and companies must pay the preferred dividend before common dividends can be paid. Most preferred is cumulative—skipped dividends must be paid before common stockholders receive a dividend. Potential gains include dividends and gains from price increases. Preferred stock issues are less frequent than common stock and are usually issued by large corporations, banks and public utilities.

Preferred stock is an example of a hybrid security. It is similar to a fixed income security because of its fixed payment and fixed liquidation value. It is similar to

equity because of the potential gain or loss in value from price changes related to firm value. Preferred stock usually has fixed dividend payments and preference during liquidation, similar to debt. But preferred stock is treated as equity for tax and accounting purposes, and it changes in value relative to changes in firm value, so it shares in capital gains.

  1. Common Stock Price Quotes

Several points to remember when discussing stock quotes:

  • The 52 week Hi and Lo are for the past 52 weeks, not since the beginning of the year.
  • The dividend is the annual dividend, based upon the most recent quarterly dividend.
  • The dividend yield (annual dividend / closing price) is different than the current yield on a bond (coupon payment / bond price).
  • The P/E ratio is based upon the current closing price divided by the most recent earnings per share.
  • The trading volume is based upon trading round lots of 100 shares, so the volume quote in the journal is multiplied times 100.
  • The Explanatory Notes are very important in determining what the special symbols mean.

Note 1: finance.yahoo.com allows you to access a variety of stock quotes—including intraday (with a 20 minute delay). The “Work the Web” using Nordstrom stock is quite a handy way to illustrate stock quotes to students.

Note 2: There are a variety of stock tickers available online. Another good one is at moneycentral.msn.com/investor. Link to CNBC and follow the on-screen directions.

  1. Derivatives

Primary asset: security sold by a business or government to raise money.

Derivative asset: an asset that is derived from an existing traded asset, rather than issued by a business or government. Any asset that is not a primary asset is a derivative asset (also called derivative security).

A primary asset is a security originally sold by a business or government to raise money, and it represents claims on the assets of the issuers. A derivative asset is derived from an existing traded asset and represents claims on other financial assets, or on the future price of a real asset. Any financial asset that is not a primary asset is a derivative asset.

  1. Futures Contracts

Futures contract: an agreement made today regarding the terms of a trade that will take place later.

A futures contract is an agreement made today regarding the terms of a trade that will take place later. The commodity, price, and time are specified in the contract. Futures contracts are standardized; specify a specific quantity, and specify in detail what the underlying asset is, and where it is to be delivered. Most futures contracts don’t result in delivery. When an investor wants out of the contract, the contract can be sold to someone else at a profit or loss. Two broad categories of futures contracts include financial futures and commodity futures.

  1. Futures Price Quotes

This is a potentially confusing area as the financial press (e.g., the Wall Street Journal) strives to save space by shortening the price quotes. Fortunately, the websites of the CME Group and NYMEX provide more information to help the students understand how option prices are quoted.

For example, corn, wheat, and soybeans are quoted in cents per bushel; live cattle are quoted in cents per hundred weight; T-notes and bonds are quoted in points and 32nd of 100%; gold is quoted in dollars per ounce, but silver is quoted in cents per ounce; heating oil and gasoline are quoted in cents per gallon, but crude oil is quoted in dollars per barrel.

Gains and Losses on Futures ContractsOnce one knows how the price of the futures contract is quoted, all that is needed to calculate gains and losses is the size of the futures contract. For example, the size of a gold contract is 100 ounces. If a trader buys one gold contract, and the gold price subsequently increases by $4 per ounce, the trader makes $400. If gold prices subsequently decrease by $4 per ounce, the trader loses $400.

A shortcut for T-notes and T-bonds is to see that each 32nd is worth $31.25 (1000 divided by 32). In the textbook example, the T-bond contract price increased by approximately 5 full points. Obviously, each full point is comprised of 32 32nd.This means the profit is 5 times 32 times $31.25, which is $5,000 per contract. If, instead, the price increases from 118 1/32 to 118 6/32, you make 5 times $31.25, or $156.25.

3.5 Option Contracts

Option contract:an agreement that gives the owner the right, but not the obligation, to buy or sell a specific asset at a specified price for a set period of time. Option contracts traded on exchanges are standardized.

  1. Option Terminology

Call option: an option that gives the owner the right, but not the obligation to buy an asset.

Put option: an option that gives the owner the right, but not the obligation to sell an asset.

Option premium: the price paid to buy an option.

Strike price: the price specified in an option contract at which the underlying asset can be bought (call option) or sold (put option). It is also known as the striking price or exercise price.

Expiration date: the last day on which an option can be exercised.

There are two basic types of options: calls and puts. The owner of a call option has the right, but not the obligation, to buy the underlying asset at a prespecified price for a specified period of time. The owner of a put option has the right, but not the obligation, to sell the underlying asset at a prespecified price for a specified period of time. The price you pay for the option is the option premium. The last day an option can be exercised is the expiration date, and the price specified at which the underlying asset can be bought (call) or sold (put) is the strike or exercise price. An American option can be exercised at any time up to

the expiration date, but a European option can be exercised only on the expiration date.

  1. Options versus Futures

Two differences exist between options and futures: the purchaser (seller) of a futures contract is obligated to buy (sell), where the owner of a call (put) option is not obligated to buy (sell). When you buy (sell) a futures contract, you pay (receive) no money. When you buy (sell) an option contract, you pay (receive) the premium.

  1. Option Price Quotes

Several fine points should be remembered when discussing option price quotes.

  • The strike prices are in standard $5 increments. Stocks that have different strike prices have had stock splits.
  • The volume for option contracts is based upon actual option contracts traded.
  • Because stock is traded in 100 share round lots, each option contract controls 100 shares of stock. Therefore, the dollar price that option buyers pay is equal to 100 times the quoted option premium (also called the option price).

Note: The finance.yahoo.com website allows you to view option chains, i.e., prices of a collection of options. See Figures 3.4-3.5 in the textbook for the vagaries of options.

  1. Gains and Losses on Option Contracts

Example: Options provide an investor an opportunity to leverage his/her investment. Suppose you, an investor, want the right to control 500 shares of Home Depot stock. Because each option contract is for 100 shares, and you want the right to buy 500 shares, you need five contracts.

The contract you decide to purchase is the Home Depot September 40 call option. Suppose the option premium for the contract with a $40 strike and a September expiration is $0.95, so one contract would cost $0.95 × 100 = $95. The cost for five contracts would therefore be 5 × $95 = $475.

Suppose you hold on to your contracts until September rolls around, and they are just about to expire. What are your gains (or losses) if Home Depot shares are selling for $55 per share? $30 per share?

If Home Depot is selling for $55 per share, you will profit handsomely. You have the right to buy 500 shares at a price of $40 per share. Because the stock is worth $55, your options are worth $15 per share, or $7,500 in all. So you invested $475 and ended up with more than 15 times that in just about three months. Not bad.

If the stock ends up at $30 per share, however, the result is not so pretty. You have the right to buy the stock for $40 when it is selling for $30, so your call options expire worthless. You lose the entire $475 that was originally invested. In fact, if the stock price is anything less than $40, then you lose $475 (plus applicable commissions and exchange fees).

  1. Investing in Stocks versus Options

To get a better idea of the potential gains and losses from investing in stocks compared to investing in options, let’s suppose you have $10,000 to invest. You’re looking at Macron Technology, which is currently selling for $50 per share. You also notice that a call option with a $50 strike price and three months to maturity is available. The premium is $4. Macron pays no dividends. You’re considering investing all $10,000 either in the stock or in the call options. What

is your return from these two investments, if, in three months, Macron is selling for $55 per share? What about $45 per share?

First, if you buy the stock, your $10,000 will purchase two round lots, meaning 200 shares. A call contract costs $400 (why?), so you can buy 25 of them. Notice that your 25 contracts give you the right to buy 2,500 shares at $50 per share.

If, in three months, Macron is selling for $55, your stock will be worth 200 shares × $55 = $11,000.Your dollar gain will be $11,000 less the $10,000 you invested, or $1,000. Because you invested $10,000, your return for the three-month period is $1,000 / $10,000 = 10%. If Macron is selling for $45 per share, then you lose $1,000, and your return is -10 percent.

If Macron is selling for $55, your call options are worth $55 – $50 = $5 each, but now you control 2,500 shares, so your options are worth 2,500 shares × $5 = $12,500 total. You invested $10,000, so your dollar return is $12,500 – $10,000 = $2,500, and your percentage return is $2,500/$10,000 = 25%, compared to 10 percent on the stock investment. However, if Macron is selling for $45 when your options mature, then you lose everything, and your return is -100%.

Chapter 4: Mutual Funds

  1. Advantages and Drawbacks of Mutual Fund Investing
  1. Advantages

Diversification, professional management, and the low required size of the initial investment are among the advantages to investing in mutual funds.

  1. Drawbacks

Three in particular are risk, costs, and taxes.

  1. Investment Companies and Fund Types

Investment company: A business that specializes in pooling funds from individual investors and investing them.

All mutual funds are investment companies, but not all investment companies are mutual funds.

  1. Open-End versus Closed-End Funds

Open-end fund: An investment company that stands ready to buy and sell shares at any time.

Closed-end fund: An investment company with a fixed number of shares that are bought and sold only in the open stock market.

The difference is in how the shares are bought and sold. A closed-end fund does not buy or sell shares; the shares are listed on organized exchanges. In an open-end fund, the fund issues new shares and invests the money received. When an investor sells shares, the fund sells some of its assets and uses the cash to redeem shares.

Sometimes an open-end fund will choose to close, meaning that the fund will no longer sell shares to new investors. The use of the word “close” here should not be confused with “closed-end,” because the number of shares can still fluctuate as existing owners buy and sell. Why would a fund choose to close? It usually happens when a fund grows so rapidly (due to good past performance) that the fund manager feels that the incoming cash is more than the fund can invest profitably. When this occurs, the fund in question is usually a small-cap fund, but large-cap funds have also closed on occasion. Funds that close may reopen at a later date.

  1. Net Asset Value

Net asset value (NAV): The value of the assets held by a mutual fund less any liabilities divided by the number of shares.

The NAV of a mutual fund changes daily and the shares are always worth their NAV. Because shares of closed-end funds are traded in the markets, their share price may not be equal to their NAV.

  1. Mutual Fund Operations
  1. Mutual Fund Organization and Creation

A mutual fund is a corporation owned by its shareholders, who elect the board of directors. Although there are many “families” of funds, each fund is a separate company. The funds are usually created by investment advisory firms, which earn the management fees. A typical management fee is 0.75%.

  1. Taxation of Investment Companies

Investment companies are treated as “regulated investment companies” for tax purposes, as long as they meet the following rules:

  • Almost all assets must be held in stocks, bonds, and other securities.
  • No more than 5% may be invested in a particular security.
  • The fund must pass through all realized investment income to shareholders.
  1. The Fund Prospectus and Annual Report

Mutual funds must provide a prospectus to any investor wanting to purchase shares. They must also provide an annual report to shareholders. The fees charged by a mutual fund are disclosed in their prospectus. These days, you can find the prospectus of many mutual funds on-line.

  1. Mutual Fund Costs and Fees
  1. Types of Expenses and Fees

Front-end load: A sales charge levied on purchases of shares in some mutual funds.

12b-1 fees:Named for the SEC Rule 12b-1, which allows funds to spend up to 1% of fund assets annually to cover distribution and marketing costs.

Turnover: A measure of how much trading a fund does, calculated as the lesser of total purchase or sales during a year divided by average daily assets.

There are four basic fees or expenses associated with mutual funds:

  • Sales charges or “loads”
  • 12b-1 fees
  • Management fees
  • Trading costs

If a fund charges a fee when shares are purchased, they are called load funds. If they don’t charge a fee, they are no-load funds. For a load fund, the investor pays the offering price, which is more than the NAV. The excess is the load. No-load funds are sold at NAV. There are also low-load funds.

Other funds have a back-end load, charged on redemptions, or a level load charged each period. They may also have a contingent deferred sales charge (CDSC), which is a back-end load that declines over time as an incentive for the investor to hold the shares.

12b-1 fees are named for the SEC rule that permits them and allows the fund to use a portion of the fund’s assets to cover distribution and marketing costs. These fees are typically 0.25% to 1.0%.

Management fees range from 0.25% to 1.0% of fund assets annually. Mutual funds also have brokerage expense from trading, so funds with high turnover would typically have much higher trading costs.

Front-end and back-end loads can add a considerable cost to the cost of a fund, especially when one considers the lost compounding of the investment. Interestingly, when comparing a front-end load to a back-end load the cost is the same. A simple numerical example will show that the total final wealth will be identical for front-end load and back-end load funds, when the load is the same percentage. Research has also shown that management fees and trading costs can impose a severe penalty on fund returns. Finally, beware of 12b-1 fees! This annual charge can turn out to be much higher than a front-end load over time. Would you rather pay a 5% front-end load or a 1% 12b-1 fee every year for ten years?

  1. Expense Reporting

Mutual funds are required to report their expenses in a standardized way in the prospectus and annual report. One item that is difficult to detect is “soft dollars,” which can increase trading costs.

  1. Why Pay Loads and Fees?

Because there are many no-load funds currently available, why would an investor consider a load fund? It may be that you want a certain fund, a specific fund manager, or a sector fund. Most specialized or sector funds require a load.

  1. Short-Term Funds
  1. Money Market Mutual Funds

Money market mutual fund (MMMF): A mutual fund specializing in money market instruments.

Introduced in the 1970’s, money market funds have grown to about 720 funds with more than $3.4 trillion in assets by late 2009.They generally invest in high-quality low-risk instruments with maturities of less than 90 days, although some funds do invest in riskier assets with longer maturities. Net asset values are “always” $1 per share. This allows MMMF’s to resemble bank accounts. It is possible for NAV to drop below $1 per share if the fund has financial difficulties. MMMF’s are either taxable or tax-exempt. Tax-exempt funds have much lower interest rates or yields.

  1. Money Market Deposit Accounts

Banks offer money market deposit accounts (MMDA).They are similar to MMMF’s, although MMDA’s offer FDIC protection, whereas MMMF’s do not.

  1. Long-Term Funds

While there are many types of long-term funds, historically funds were classified as stock, bond, or balanced funds. Now there are many classifications. Investors should carefully investigate the holdings of a fund because the stated investment objective may not concur with the actual portfolio holdings of a fund.

  1. Stock Funds

Capital Appreciation versus Income

  • Capital appreciation
  • Growth
  • Growth and income
  • Equity income

Company Size-Based Funds

  • Small company
  • Midcap
  • Large company

International Funds

  • Global
  • International

Sector Funds

Other Fund Types and Issues

  • Index funds
  • Social conscience funds
  • Tax-managed funds
  1. Taxable and Municipal Bond Funds

Most bond funds invest in corporate and government securities. There are five characteristics that distinguish bond funds:

  • Maturity range
  • Credit quality
  • Taxability
  • Type of bond
  • Country

Bond fund types include:

  • Short-Term and Intermediate-Term Funds
  • General Funds
  • High-Yield Funds
  • Mortgage Funds
  • World Funds
  • Insured Funds
  • Single-State Municipal Funds
  1. Stock and Bond Funds

Stock and bond funds invest in both types of securities, and are also called “blended” or “hybrid” funds. Fund types include:

  • Balanced Funds
  • Asset Allocation Funds
  • Convertible Funds
  • Income Funds
  • Target Date (Lifecycle) Funds
  1. Mutual Fund Objectives: Recent Developments

A mutual fund’s stated objective may not be all that informative. In recent years, there has been a trend toward classifying a mutual fund’s objective based on its actual holdings. For example, Figure 4.3 illustrates the classifications used by The Wall Street Journal.

A key thing to notice in Figure 4.3 is that most general-purpose funds (as opposed to specialized types such as sector funds) are classified based on the market “cap” of the stocks they hold (small, midsize, or large) and also on whether the fund tends to invest in either “growth” or “value” stocks (or both).

The mutual fund “style” box is an increasingly common sight. A style box is a way of visually representing a fund’s investment focus by placing the fund into one of nine boxes like this:

STYLE
SIZEValueBlendGrowth
Large
Medium
Small

As shown, this particular fund focuses on large-cap, value stocks. These newer mutual fund objectives are also useful for screening mutual funds. We have included a Work the Web box to show how many Web sites have mutual fund selectors that allow you to find funds with particular characteristics.

  1. Mutual Fund Performance
  1. Mutual Fund Performance Information

There are many sources of mutual fund performance information, including: Morningstar, the Wall Street Journal, and Value-Line. There are also many web sites that provide mutual fund information. Several of these web sites are noted at the beginning of this chapter.


How Useful are Fund Performance Ratings?


When reviewing performance ratings, it is important to point out that the best performing fund this year may have performed very poorly over the past five years (or vice versa). These historical performance measures are not necessarily good predictors of future performance. Also, the riskiest funds may do the best during a rising market, but they will probably perform the poorest during a declining market. Funds are continually changing the fund manager as well. This information may take additional research to uncover.

  1. Closed-End Funds, Exchange-Traded Funds, and Hedge Funds
  1. Closed-End Funds Performance Information

Remember, closed-end funds offer a fixed number of shares, and these shares are bought and sold on the open market. The closed-end fund quotes are listed with the other common and preferred stock listings contained in the stock tables for established exchanges, such as the NYSE. The closed-end fund quotes have “Fd” as part of the name and do not have P/E ratios listed.

  1. The Closed-End Fund Discount Mystery

Because shares in closed-end funds trade in the marketplace, share prices typically differ from the NAV. Interestingly, most closed-end funds trade at a discount from NAV. This appears to allow investors to buy stock at a discount through closed-end funds. This discount also fluctuates over time, sometimes it is very wide, and at other times it almost disappears. If an investor interprets funds trading at a large discount as a good investment, this may not be the case. For the investor to profit, the discount must narrow. Occasionally closed-end funds will sell at a premium to NAV. This is similar to a front-end load. Closed-end funds are initially sold to the public as an IPO, and the price is equal to the fund’s NAV. Since the fund promoter is paid a fee “right off the top,” and the fund will likely start selling at a discount. Therefore, newly offered closed-end funds are generally not good investments.

  1. Exchange-Traded Funds

Exchange traded funds (commonly called ETF’s) are a relatively recent innovation. They began about 1993, but their growth mushroomed in the late 1990s. As of 2009, there were over 700 ETFs trading.

Basically, an ETF is an index fund. When an investor buys an ETF, the investor owns a basket of securities. A well-known ETF is the “Standard and Poor’s Depositary Receipt” or SPDR. This ETF is the S&P 500 index, and it is commonly called “spider.” An ETF that represents the Dow Jones Industrial Average is commonly called “diamond.”

ETFs trade like a closed-end fund. They can be traded intra-daily, and can be sold short. They generally have low fund expenses, but investors must pay commissions when they are purchased and sold. However, due to redemption units, they generally trade close to NAV.

Leveraged ETFs are a relatively recent addition to those available. These generally track the intended benchmark (at 2X or negative 2X, or more) over very short periods (i.e., daily). However, over longer periods both fund types experience lower returns than would be expected.

  1. Hedge Funds

Hedge funds are like mutual funds, in that a hedge fund manager has a pool of money obtained from investors. Unlike mutual funds, however, hedge funds are not required to register with the Securities and Exchange Commission. Also, hedge funds are not required to maintain any particular degree of diversification or liquidity. Basically, hedge fund managers have considerable freedom to follow various investment strategies. Investors in hedge funds generally must qualify as “financially sophisticated” investors.

The fee structure generally includes a management fee (often around 2%) and a performance fee, generally 20% of profits. However, the performance fee is subject to a high water mark to prevent manipulation.

Types of hedge funds include: market neutral (long/short), arbitrage, distressed, macro, short, and market timing. Each brings its own approach and level of risk.

Fund of funds have become popular, but the downside is the added layer of fees, which generally drags on performance.

Source: Jordan, B., Miller, Jr., T., & Dolvin, S. (2012). Fundamentals of investment: Valuation and managment. (6th ed.). New York, NY: McGraw-Hill.

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