Section 7: Investments Overview Concepts you’ll learn 1.Stocks 2.Stock Indices 3.Bonds 4.Rate of...

Section 7: Investments Overview

Concepts you’ll learn1. Stocks2. Stock Indices3. Bonds4. Rate of Return5. Investment Risk6. Diversification7. Mutual Funds8. Commissions and Fees

Problems you’ll solve– Define major investment vehicles– Classify investments with respect to general rate of return and risk– Understand how to manage risk through diversification– Understand how risk management goals vary depending personal

circumstance– Understand how to minimize transactions costs

©2014 D. M. Kaufman. All rights reserved

Investments – Definitions• Stock: A type of security that signifies ownership in a corporation and represents a claim on part of

the corporation's assets and earnings. There are two main types of stock: common and preferred. Common stock usually entitles the owner to vote at shareholders' meetings and to receive dividends. Preferred stock generally does not have voting rights, but has a higher claim on assets and earnings than the common shares. For example, owners of preferred stock receive dividends before common shareholders and have priority in the event that a company goes bankrupt and is liquidated.

• Stock Index: An aggregate value produced by combining several stocks or other investment vehicles together and expressing their total values against a base value from a specific date. Market indexes are intended to represent an entire stock market and thus track the market's changes over time.

Index values are useful for investors to track changes in market values over long periods of time. For example, the widely used Standard and Poor's 500 Index is computed by combining 500 large-cap U.S. stocks together into one index value. Investors can track changes in the index's value over time and use it as a benchmark against which to compare their own portfolio returns.

• Bond: A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities.

• Rate of Return: The gain or loss on an investment over a specified period, expressed as a percentage increase over the initial investment cost. Gains on investments are considered to be any income received from the security plus realized capital gains.

• Investment Risk: The chance that an investment’s actual return will be different than expected. This includes the possibility of losing some or all of the original investment. Risk is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.

A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk.

For example, a U.S. Treasury bond is considered to be one of the safest investments and, when compared to a corporate bond, provides a lower rate of return. The reason for this is that a corporation is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher, investors are offered a higher rate of return.

• Diversification: A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

• Mutual Fund: An open ended fund operated by an investment company which raises money from shareholders and invests in a group of assets, in accordance with a stated set of objectives. Mutual funds take the money they receive from investors (along with any money made from previous investments) and use it to purchase various investment vehicles, such as stocks, bonds, and money market positions. In return for the money they give to the fund when purchasing shares, shareholders receive an equity position in the fund and, in effect, in each of its underlying securities. For most mutual funds, shareholders are free to sell their shares at any time, although the price of a share in a mutual fund will fluctuate daily, depending upon the performance of the securities held by the fund. Benefits of mutual funds include diversification and professional money management. Mutual funds offer choice, liquidity, and convenience, but charge fees and often require a minimum investment.

• Commission: A service charge assessed by a broker or investment advisor in return for providing investment advice and/or handling the purchase or sale of a security. Most major, full-service brokerages derive most of their profits from charging commissions on client transactions. Commissions vary widely from brokerage to brokerage.

Looking At the Grand Scheme...

• Notice that individual stocks can give you either the best or the worst returns, depending on when you buy and when you sell (and market timing is very difficult).

• A bundle of stocks (in this case, the stock indices) tend to give the best returns over long time periods, but they can go down in value over the short term

• Bonds tend to stay slow and steady, but they give a stronger likelihood of preserving your principal or cost basis

IntelFidelity U.S. Bond Index

(mutual fund)

Fidelity Total Market Index (mutual fund)

JDS Uniphase

Dow Jones Index

S&P 500

Basic Scenario Planning

• Let’s say you’re saving money to buy a car in five years. Which type of investment would you pick?

t1 t2 t3

During these 5 years:• INTC earned the most• The stock indices yielded decent gains• We don’t have bond data for this

period, but they likely would have yielded modest gains

t1 t2 t3During these 5 years:• JDSU exploded• INTC did very well• The stock indices yielded

very good gains• Bonds yielded modest gains

During these 5 years:• JDSU tanked• INTC declined sharply• The stock indices

declined slightly• Bonds yielded modest gains

Notice that the highest risk, highest return choices don’t always play out the best over limited time horizons

Basic Scenario Planning (cont.)

• Let’s say, in 1997, you start saving for retirement in 2030. Which type of investment would you pick?

So far:• JDSU would have first elated and then killed you (you’d have less money overall).• INTC would have you slightly up – and it could tank at any time, since it’s just one stock.• The stock indices are slightly up, and are somewhat protected from sharp declines by

diversification – if bad news hits any one stock the general market is unlikely to be affected. Of

course, the entire market can still decline in value (as it did from 2000 through 2003).• The bonds have just plugged along at the bottom – earning very modest (but positive) returns.

In this hypothetical, you still have time on your side

Basic Scenario Planning (cont.)

• Let’s say, in 1998, you invest $500,000 towards retirement in 2003. Which type of investment would you pick?

• JDSU would be a disaster• INTC would have you slightly down• The stock indices are basically flat – you’d pretty much have what you started with• The bonds have just plugged along – but your money would have grown slightly

In this hypothetical, the individual stocks = disaster and the stock indices are still risky. Bonds do a better job of growth + capital preservation as retirement looms.

Let’s Zero In a Bit

• Notice anything interesting about the peaks highlighted here?

• The two individual stocks have the sharpest peaks, while the indices are more muted. Why?• There is a whacky regression statistic called “beta,” which is a measure of risk associated with a given stock.• The entire stock market, with all its diversification across thousands of stocks, is defined as having a beta of

1. A stock with a beta greater than 1 will typically exhibit larger percentage swings (both positive and negative) than the market. A stock with a beta less than one will exhibit lower percentage swings than the market. A stock with a beta of 1 will typically track the market.

• The two individual stocks listed here are considerably more risky than the market. Higher risk is more richly rewarded in good times and more severely punished in bad.

More on Mutual Funds and Fees

• As stated on the “definitions” page, mutual funds provide a quick path to diversification (avoiding the extreme peaks and valleys we saw on the previous page).– i.e. To diversify a stock portfolio by buying 1 share of each S&P 500

company (that’s 500 different shares of stock), you’d have to pony up tens of thousands of dollars, and even then your investment would not be value weighted. In order to achieve value weighting, you’d have to pony up hundreds of thousands.

– With a mutual fund, you can achieve the same goal with only a few hundred dollars, because you can essentially buy fractional shares.

• Furthermore, you can avail yourself of professional money management with mutual funds, depending on the fund’s prospectus, but...

• ...beware of management fees.• Speaking of fees, understand that, in general, the more

money management services you engage, and the more often you buy and sell securities, the more commissions and fees you will pay.

• We’ll talk in more detail about all of this over the next few sections.

So, A Few Guidelines...

• Diversification is key to managing risk• There are various levels of diversification

1. Most risky: investing 100% in a single stock2. Very risky: investing 100% in a handful of stocks3. Risky: investing 100% in stocks, stock mutual funds, and stock indices 4. Moderately risky: investing in a balance of stocks (and/or stock mutual

funds ad indices) and highly rated bonds and/ bond mutual funds. Junk bonds are a different story, and we’ll talk more about those later.

5. Less risky: investing in a balance of stocks (and/or stock mutual funds and indices), bonds and/or bond mutual funds, and savings instruments (i.e. the savings accounts, money markets, and CDs discussed in the previous section).

6. Less risky still: investing in bonds and/or bond mutual funds, and savings instruments.

7. Are you really that afraid of life?: investing in savings instruments only.• Where you fall on this risk/reward spectrum should

depend on your age and your investment goals. See the next page

Potential Portfolio Mix Examples

StocksBondsCash Equ.




5%95%

20%70%

10%

40%20%

40% 60%

20%20%

Young, with no near or mid term needs to withdraw or

spend your money on

Still young, but with a few major planned expenditures coming up

in the next few years

Major stuff on the horizon. Perhaps paying for kids’ college, or

retirement in the next few years, etc.

Retired. Still want some potential growth but need to

preserve capital.

And don’t forget to properly diversify within each asset class. “20% stocks,” for example, doesn’t necessarily mean 20% of

your portfolio invested in one single stock.

Section 7: Practice Problem• Start thinking about how you’d want your investment

portfolio to look under the following scenarios (because you’ll be constructing a virtual portfolio in the next couple of weeks). How would you diversify across the major asset classes if: 1. You’re young and single, with 40+ years until retirement.2. You’re young and married with 2 kids, with 30+ years until retirement.3. You’re middle aged, with about 10 years until retirement.4. You’re retired.

• Spend the most time thinking about scenario 1 – that’s what you’ll build your virtual portfolio around.

Section 8: Stocks (Details)

Concepts you’ll learn1. Share Price2. Volume3. Bid-Ask Spread4. Shares Outstanding5. Market Cap6. Corporate Earnings or Net Income7. P/E Ratio8. Dividends9. Splits10. Sectors11. Moving Average12. Quarterly Earnings Report13. Brokerage account14. Market Order15. Limit Order16. Stop Loss Order17. Short Selling18. Capital Gain19. Margin

Problems you’ll solve– Understand key stock health indicators– Calculate returns associated with stock investments– Understand how to diversify a stock portfolio across sectors and cap sizes– Understand how to minimize transactions costs


Public Service Announcement

The point of this section is to teach you how to evaluate stocks as long-term investments, not

for short-term speculation. There is no safe way to “place bets” on stocks for short-term gains. Some (lucky) people get rich doing it,

but many (unlucky ones) go broke. If you want to risk everything you’ve got on short-term

time horizons you may as well go to Vegas.

So, if anyone asks you whether you learned to “bet” on stocks in this class, the answer is no.

But you may learn how to invest in them.

Stocks – Definitions• Share Price: The price of one share of stock• Volume: The number of shares or contracts traded in a security or an entire market

during a given period of time. It is simply the amount of shares that trade hands from sellers to buyers as a measure of activity. If a buyer of a stock purchases 100 shares from a seller, then the volume for that period increases by 100 shares based on that transaction.

• Bid-Ask Spread: The amount by which the ask price exceeds the bid. This is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it. In general, the lower the spread, the more liquid, or actively traded, the stock is (i.e. higher volume).

• Shares Outstanding: Stock currently held by investors, including restricted shares owned by the company's officers and insiders, as well as those held by the public. Shares that have been repurchased by the company are not considered outstanding stock. This is not the same as the “float,” which is the number of shares owned by the public and available for sale.

• Market Capitalization: The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying a company's shares outstanding by the current market price of one share. The investment community uses this figure to determining a company's size, as opposed to sales or total asset figures.

– Large Cap: $10 billion plus – Mid Cap: $2 billion to $10 billion – Small Cap: Less than $2 billion

• Corporate Earnings: The amount of profit that a company produces during a specific period, which is usually defined as a quarter (three calendar months) or a year. Earnings typically refer to after-tax net income.

• Price/Earnings Ratio: A valuation ratio of a company's current share price compared to its per-share earnings. The formula is: Share Price / Earnings Per Share (EPS). EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

• Quarterly Earnings Report: A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net income, earnings per share, earnings from continuing operations and net sales.

Stocks – Definitions (cont.)• Dividend: A distribution of a portion of a company's earnings, decided by the board of

directors, to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share). It can also be quoted in terms of a percent of the current market price, referred to as dividend yield.

• Stock Split: A corporate action in which a company's existing shares are divided into multiple shares. Although the number of shares outstanding increases by a specific multiple, the total dollar value of the shares remains the same compared to pre-split amounts, because no real value has been added as a result of the split.

• Sector: An area of the economy in which businesses share the same or a related product or service, or a group of securities in the same industry or market. It’s important to examine how a given stock is positioned relative to other stock in its sector, and how the sector as a whole is positioned relative to the overall market. Finally, a well diversified portfolio will contain stocks from multiple sectors.

• Brokerage Account: An arrangement between an investor and a licensed brokerage firm that allows the investor to deposit funds with the firm and place investment orders through the brokerage, which then carries out the transactions on the investor's behalf. The investor owns the assets contained in the brokerage account and must usually claim as income any capital gains he or she incurs from the account.

• Market Order: A buy or sell order in which the broker is to execute the order at the best price currently available.

• Limit Order: An order placed with a brokerage to buy or sell a set number of shares at a specified price or better. Limit orders also allow an investor to limit the length of time an order can be outstanding before being canceled.

• Stop Loss Order: An order placed with a broker to sell a security when it reaches a certain price. It is designed to limit an investor's loss on a security position.

• Short Selling: The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.

• Capital Gain / Loss: An increase / decrease in the value of an asset or property. • Margin: Borrowed money that is used to purchase securities. This practice is referred

to as "buying on margin". Buying with borrowed money can be extremely risky because both gains and losses are amplified.

• Margin Call: A broker's demand on an investor using margin to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin.

One Last Definition: Simple Moving Averages• A simple, or arithmetic, moving average that is calculated by adding the closing price

of the security for a number of time periods and then dividing this total by the number of time periods. Short-term averages respond quickly to changes in the price of the underlying, while long-term averages are slow to react.

In other words, this is the average stock price over a certain period of time. Keep in mind that equal weighting is given to each daily price. As shown in the chart above, many traders watch for short-term averages to cross above longer-term averages to signal the beginning of an uptrend, but it’s less of a key indicator over the longer term. As shown by the blue arrows, short-term averages (e.g. 15-period SMA) act as levels of support when the price experiences a pullback. Support levels become stronger and more significant as the number of time periods used in the calculations increases.

A stock that is trading above its SMAs is typically either overpriced or enjoying positive earnings / business growth. You need to evaluate which is the truth.

A stock that is below its SMAs is typically either underpriced or suffering some business setback. You need to evaluate which is the truth.

Looking At a Few Stocks

Interested in any of these?

Let’s Look Closer At INTC

What’s going on here? A huge, profitable company with limited growth prospects?

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INTC is profitable. EPS is positive, and P/E ratio equals ~45.

They pay a small dividend, improving returns.

This is a huge company; market cap > $100B.

High avg. volume and tight bid-ask spread suggest a very liquid stock.

Analysts don’t expect the stock to go too much higher in the next year (not quite 8%)

INTC tends to follow the market, but with a beta > 1.

INTC barely above its 15 and 50 day moving averages

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Digging Deeper Into INTC• INTC’s P/E ratio is 40+. But is that good or bad? Consider:

– Historical Index P/E ratios:• The historical average P/E ratio for the DJI is ~12• The historical average P/E ratio for the S&P 500 is ~15

– So, INTC is a huge company and deserves to be held to the same standard as a market index – it is no longer a small company with potential for explosive growth.

• Why else might INTC’s near-term growth prospects be limited?– INTC is one of a very few suppliers of microprocessors to the personal computer (PC)

market, and they dominate. So, they’re huge, but they can’t grow within the existing PC market – the entire PC market has to grow for INTC to grow significantly.

– Even though INTC can’t grow within the current PC market, INTC’s competitors can – all they have to do is take business away from INTC. Certain surprise announcements to this effect are a potential driver for those occasional steep declines we see in INTC’s stock chart, after which INTC has to claw its way back to regain lost business.

– INTC is barely above its 50 DMA (50 day moving average), suggesting the stock might be overpriced.

– INTC’s 15 DMA looks like it’s about to cross the 50 DMA, suggesting a flat-to-down trend. Will it continue…?

• There are still reasons why you might want to buy and hold INTC over the long term, but you should go in with eyes wide open. Do you think the analysts are wrong (they’ve been wrong before) and that INTC will grow more in the next year than they believe? Or do you think that INTC’s growth prospects beyond this year are good, so you want to get in now?

• If not, don’t put money into INTC at this time. You decide.

1. Invest only in stocks which you thoroughly understand.2. If you’re not willing or able to do research like this, you have no business

picking individual stocks. Stick with mutual funds and/or indices.

Now, Let’s Look Closer At GE

Hmm. Bleaker growth prospects then INTC, but why? And what happened on April 11th, 2008??

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GE is profitable. EPS is positive, and P/E ratio equals ~13.5.

They pay a decent dividend, improving returns.

This is a huge company; market cap over $175B.

High avg. volume and N/A bid-ask spread suggest a very liquid stock.

Analysts expect GE to decline over the next year.

April 11th, 2008 -- hammered! What happened??

GE is above its 15 and 50 day moving averages

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Digging Deeper Into GE

• GE’s P/E ratio is ~13. – The historical average P/E ratio for the S&P 500 is ~15.– The DJI historical average is ~12.– GE’s P/E ratio is in line with historical market averages. Not bad.

• What in the hell happened on April 11th, 2008??– “In an interview on CNBC, CEO Jeff Immelt blamed the sudden collapse of Bear Stearns

and the worsening credit crunch for GE's earnings surprise. He also described the poor results as a ‘bump in the road,’ though the company lowered its earnings outlook for the entire year. -- Source: CNBC, 4/11/08

• More info:– General Electric Company (GE) operates as a technology, media, and financial services

company worldwide. It operates through four segments: GE Capital, Energy Infrastructure, Technology Infrastructure, and NBC Universal. The GE Capital segment offers an array of products and services that include commercial loans, operating leases, fleet management, financial programs, home loans, insurance, credit cards, personal loans, and other financial services. The Energy Infrastructure segment involves in the development, implementation, and improvement of products and technologies that harness various resources, such as wind, oil, gas, and water. The Technology Infrastructure segment focuses on building healthcare, transportation, and technology infrastructure. The NBC Universal segment develops, produces, and markets film, television, news, sports, and special events. – Yahoo Finance

• So we’ve got a huge, profitable, highly diversified, international conglomerate (paying out a small dividend) that took a beating over a bad earnings statement and declined since at a faster rate than the market. Long-term buying opportunity? Farther to fall? You decide, but you’d probably have to dig even deeper on this one. Has management gone through a bunch of recent turnover? How does their balance sheet look? Let’s take a look at their financial details...

And Still Deeper on GE

Okay, what have we got here...?

– Profit margins are positive (we already knew that), but which way are they heading?

– Hmm. Quarterly revenue (total money taken in) down by 16%+ from the same time period last year (yoy = Year Over Year), and net earnings shrank by almost 50%. GE’s sales are falling and their cost of doing business must be going way up (inflation? rising oil prices?). Will that continue?

– Whoa! They’ve got a lot of debt. What’ll happen with that?

So, this is probably why GE hasn’t recovered back to the market trend line. They won’t go out of business anytime soon and may be a good long-term investment, but is now the time to get in? Again, you decide.

Now, It’s WFC’s and XOM’s Turns

• We don’t need to do the same type of analysis on these guys, but let’s say you bought both at the “last trade” prices, held them for a year, and both exactly hit the analysts’ 1yr Targets. How much money would you make?– WFC:

• Your cost basis is $28.90. The 1yr target is $29.30. Your capital gain is 29.30 – 28.90 = $0.40.

• You also are expected to receive quarterly dividends totaling $0.20 for the year.• Your total return is 0.40 + 0.20 = $0.60, or 0.60 / 28.90 = 2.08%.

– XOM:• Your cost basis is $69.59. The 1yr target is $76.58. Your capital gain is 76.58 –

69.59 = $6.99.• You also are expected to receive quarterly dividends totaling $1.68 for the year.• Your total return is 6.99 + 1.68 = $8.67, or 8.67 / 69.59 = 12.46%.

– Side note: historical average stock market returns are ~8% annually, so if the analysts are right, and the dividends hold, the return on XOM would be pretty sweet, and WFC would be a bit weak…

– ...But, are they right? You decide.

More On Short Selling

• Short selling is almost always a risky, short term bet, and I don’t recommend it. Here’s why:

• Whether you think INTC is a wise investment right now or not, the most you can lose on a share of it is ~$20. The upside, however, over a long period of time, is unlimited.

• But if you sell it short, you pay interest until you buy back, and if the amount of money in your brokerage account drops until it’s exactly the amount you would need to repurchase the shares (plus paying commissions), your broker will automatically repurchase the shares to square up your account – leaving you with about $.01. So short selling is almost always a short term play, and...

• The most you can make is ~$20/share, because you’re hoping to repurchase at a lower price, and the price can’t go any lower than zero. But because a stock price can rise indefinitely, the most money you can lose as a short seller is also indefinite. That’s a losing proposition, I think. Again, people make money doing it, but a lot also go broke.

More on Margin Buying• Here are some details on how it works:

– Let’s say you have $1,000 to invest. Your brokerage firm agrees to lend you up to 50% of your total investment. So, you’re putting in $1,000, and they’re loaning you another $1,000.

– Next, you invest the entire $2,000 in 200 shares of ABC Company at $10 a share. You agree to keep $1,000 in assets in your account at all times to cover this loan.

– What happens next? Let's look at two scenarios.• Scenario 1: The stock rises to $12 a share – a 20% gain.

– You could sell the shares for $2,400 – a 40% return on your original $1,000 investment – You would pay back the loan, with interest, and pay a sales commission to your broker – After costs, your profits would be higher than if you had invested without borrowing.

• Scenario 2: The stock drops to $8 a share – a 20% loss– You will have a loss of $400 on paper. You could sell the shares and take your losses, or you

could hold on to the shares in the hope that they may go up again sometime in the future – You still have to pay commissions to buy the stock, plus the interest on your loan – You will also have to put money back into your investment account. Why? Your brokerage

firm only agreed to lend you up to 50% of the total you have invested. This total is now just $1,600, down from $2,000. That means you can carry a balance of only $800 on margin. Clearly, you are over your limit, because you owe your broker $1,000. So, you will get a margin call to set it right. You’ll have to put $200 of your own money back into the account. So, you’re 40% down instead of 20%, and you’re digging into pocket to buy time until things improve, while paying interest. Sounds a lot like someone in Vegas withdrawing money from an ATM, praying that their luck will change.

• Again, not recommended as a sound long-term investment strategy

A Bit More on Diversification

If we were to buy each of these, would we be diversified?

• Let’s look again at our old friends

A Bit More on Diversification (cont.)

We’re diversified across sectors, but not across market cap size

• The answer is: yes and no.

Technology Sector

Financial Sector

Conglomerate Sector

Energy Sector

Large Cap

Large Cap

Large Cap

Large Cap

A Bit More on Diversification (cont.)

Bottom line: there’s no law against investing solely in one market cap size but, once again, diversification has its benefits

• Diversification across sectors is probably the more important of the two, because sectors tend to run hot and cold

• Still, diversification across cap sizes can also be desirable– Cap sizes can run hot and cold too– When the smaller cap companies get hot, they can provide the

most amazingly spectacular returns. You’ll never be able to time it perfectly – that is, get in just before a hot streak begins and get out just before it ends – but if you have a few in your portfolio at all times, you’ll see some crazy good results every so often. They’re also risky, but with enough diversification into larger companies and across sectors you should still be okay over the long haul.

Public Service Announcement (revisited)

If you’re not already convinced that making a bunch of risky short-term bets is less desirable than

making a few deliberate, long-term investments, consider the following:

Each time you buy or sell a stock, you have to pay commissions. Don’t “churn and burn” yourself.

The best way to keep your commissions and fees low is: make a few, well thought out, long term investments, and make them yourself with an

inexpensive online broker. Full-service brokers will give you all kinds of advice – and charge higher

commissions for it – and may rob you blind.

Section 8: Practice Problems

1. How many shares does GE have outstanding?2. If you owned a share of GE, what quarterly dividend would

you expect to receive?3. If you pay the “last trade” price for a share of GE, hold it for a

year, and the analysts’ 1y target turns out to be precisely accurate, what return will you make?

4. Would you expect GE to suffer a huge share price decline as a result of bad earnings news in the technology sector?

5. If you sold GE short at the “last trade” price, what’s the most per share you could earn? What’s the most you could lose?

6. If you buy 100 shares of GE at the “last trade” price on 50% margin, and the price then increases by 25%, what would the return on your investment be? How about if the price decreases by 25%?

Class Exercise #2: Stock Portfolio

Rules1. You start with $10,000 in virtual money.2. On the day you open your portfolio (i.e. the day you present your portfolio to the

class), you’re allowed up to 10 trades.3. The primary idea of this exercise is to select individual stocks (i.e. do your research),

but you may also elect to leave a portion of your money in cash and (or) in bonds– Leaving a portion of your initial money in cash and (or) bonds doesn’t count as one of your

initial 10 trades– Money left in cash and (or) bonds will not accrue interest or yield a return. This is not true to

life, but it’s the only way to make this exercise manageable over the remainder of the course. 4. You may buy any publicly traded individual stock on the NYSE or NASDAQ exchanges,

in any full share increment.5. You may also buy a fictional mutual fund that exactly tracks the performance of the

S&P 500, in any full penny increment. This is a magical mutual fund that doesn’t charge any management fees.

6. After you present your portfolio to the class, your trades will be recorded.7. We’ll track your portfolio performance every few days.8. The one with the most money at the end of the course wins.

Grading– You’ll be graded on the initial construction of your portfolio.– Of primary importance is your ability to defend your decisions. i.e. How much risk

are you taking on? Why? Are you diversifying with bonds and cash or jumping headlong into stocks? Why? With respect to the stocks you purchase, are you diversified? How? Why? Have you researched the companies thoroughly? Can you prove it?

Final rule: you can’t pick any of the stocks contained in the following “portfolio presentation example” foils.


Targeted Asset Mix

• Personal Status– Age: 37– Married– Two kids, age 6 and 3– Debt free– Planning early retirement

• College expenses for the little grommets aren’t too far off.• Retirement could be as early as ~15 years from now –

coinciding with kids’ college expenses. Ouch.• Debt free status means fixed living expenses are low – we

can take some investment risks.• Summary: Need aggressive growth from stocks while

preserving some capital for looming big-ticket expenses and income reductions. A total or near total loss would be devastating.

Portfolio Presentation – 2008 Example

60%30%

10%

StocksBondsCash

• Initial funding: $10,000• Initial investments:

– $2,000 in cash (targeting another $1,000 to go into stocks soon, but holding in reserve for now)

– $3,000 in bonds– $5,000 in stocks

• Initial stock picks:– 30 shares Disney (DIS)– 35 shares Bank of America (BAC)– 50 shares Pfizer (PFE)– $2,047.70 in S&P 500 Index Fund

Portfolio Presentation – Example (cont.)

• Stock diversity– Strong diversity across sectors with

S&P 500 position, plus heavier positions in pharmaceuticals (PFE), entertainment (DIS), and finance (BAC).

– Pharma and entertainment tend to be somewhat recession proof, and our economy is weak right now.

– Finance is a contrarian position – it’s been beaten way down and I’m hoping for a turnaround.

– All large cap positions. May miss out on positive moves in small cap, but today’s small cap trend is down and I don’t want to risk outsize losses.


• Specifically, why Disney?– Fairly diversified as entertainment

companies go – film, TV, travel, and merchandise.

– Very strong worldwide brand.– Pixar acquisition and Steve Jobs board

seat ensures “cutting edge” adoption of distribution technology.

– Highly profitable – strong P/E ratio– Slight dividend bonus– Slight revenue growth...– ...Outpaced by 9% quarterly earnings

growth yoy – this company has expenses under control

– Highly solvent (see debt/equity ratio of ~.4)

– Key Risks: terrorist attack, movie flops, Steve Jobs health


• Specifically, why BAC?– Less exposed to the current mortgage

crises (they packaged and sold off most of their sub-prime loans).

– Hoping we’ve seen most of the bad news in the financial sector (and earnings growth will start to recover)

– Reasonable P/E ratio– Strong earnings (negative earnings

growth notwithstanding)– Strong dividend provides a nice cushion

against potential capital loss– Betting that this company will recover

from any short term risk over the next 15 years while providing a nice dividend.

– Key risks: More bad news in financials, earnings continue to slow, BOD suspends the dividend, (sizeable) debt becomes unmanageable.


• Specifically, why PFE?– People will always need their medicines– Strong product pipeline– Strong earnings with amazing quarterly

earnings growth yoy (119%)– Reasonable P/E ratio– Decent dividend provides a nice cushion

against potential capital loss– Very low debt/equity ratio– Key risks: Product pipeline setbacks with

the FDA


Initial position summary and cost basis

Cash $2,000Bonds $3,000Stocks $5,000

S&P 500 $2,047.70DIS $ 952.50 (30 shares @ $31.75)BAC $ 982.80 (35 shares @ $28.08)PFE $ 967.00 (50 shares @ $19.34)

TOTAL $10,000


Little opportunity here for explosive growth, but well set up for healthy gains. Given my age and

goals, that’s an okay trade off.

Section 7: Investments Overview Concepts you’ll learn 1.Stocks 2.Stock Indices 3.Bonds 4.Rate of...

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Transcript of Section 7: Investments Overview Concepts you’ll learn 1.Stocks 2.Stock Indices 3.Bonds 4.Rate of...