Investments an introduction 9th ed herbert b mayo

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“No matter what accomplishments you make, somebody helps you.”

This quote from Althea Gibson and on display in the American pavilion at Epcot in

Disney World certainly applies to me Investments: An Introduction, Ninth Edition,

is dedicated to four of my colleagues at The College of New Jersey, who in different ways have helped me “accomplish.” They are, in alphabetical order:

Thomas Breslin

Nancy Lasher

Bozena Leven

Thomas Patrick

Series in Finance

Finance–General

Personal Finance

Boone/Kurtz/Hearth: Planning Your Financial Future, 4e

Gitman/Joehnk: Personal Financial Planning, 11e

Survey of Finance

Besley/Brigham: Principles of Finance, 3e

Mayo: Basic Finance: An Introduction to Financial Institutions, Investments, and Management, 9e

Entrepreneurial Finance

Leach/Melicher: Entrepreneurial Finance, 2e

Corporate Finance

Corporate Finance/Financial Management—Undergraduate

Aplia: Aplia for Finance

For: Besley/Brigham 14e

Brigham/Houston: Concise 5e

Brigham/Houston: Fundamentals 11e

Besley/Brigham: Essentials of Managerial Finance, 14e

Brigham/Houston: Fundamentals of Financial Management, Concise 5e

Brigham/Houston: Fundamentals of Financial Management, Concise 5e Hybrid TextBrigham/Houston: Fundamentals of Financial Management, 11e

Brigham/Houston: Fundamentals of Financial Management, 11e Hybrid TextLasher: Practical Financial Management, 5e

Megginson/Smart: Introduction to Corporate Finance

Moyer/McGuigan/Kretlow: Contemporary Financial Management, 10e

Moyer/McGuigan/Rao: Fundamentals of Contemporary Financial Management, 2e

International Finance

Butler: Multinational Finance, 3e

Crum/Brigham/Houston: Fundamentals of International Finance

Madura: International Financial Management, 9e

Madura: International Financial Management, Abridged 8e

Intermediate/Advanced Undergraduate Corporate Finance

Brigham/Daves: Intermediate Financial Management, 9e

Working Capital Management/Short-Term Financial Management

Maness/Zietlow: Short-Term Financial Management, 3e

Valuation

Daves/Ehrhardt/Shrieves: Corporate Valuation: A Guide for Managers and Investors

MBA/Graduate Corporate Finance

Brigham/Ehrhardt: Financial Management: Theory and Practice, 12e

Ehrhardt/Brigham: Corporate Finance: A Focused Approach, 2e

Hawawini/Viallet: Finance for Executives: Managing for Value Creation, 3e

Smart/Megginson/Gitman: Corporate Finance, 2e

Weaver/Weston: Strategic Financial Management

Corporate Finance/Supplemental Products

Aplia: Preparing for Finance

Klein/Brigham: Finance Online Case Library

Mayes/Shank: Financial Analysis with Microsoft® Excel, 4e

Strong: Practical Investment Management, 4e

Derivatives/Futures and Options

Chance/Brooks: An Introduction to Derivatives and Risk Management, 7e

Stulz: Risk Management and Derivatives

Reilly/Brown: Investment Analysis and Portfolio Management, 8e

Strong: Portfolio Construction, Management, and Protection, 4e

Financial Institutions and Markets

Madura: Financial Markets and Institutions, 8e

Madura: Financial Markets and Institutions, Abridged 7e

Money and Capital Markets

Liaw: Capital Markets

Commercial Banking/Bank Management

Koch/MacDonald: Bank Management, 6e

Insurance

Risk Management and Insurance/Introduction to Insurance

Trieschmann/Hoyt/Sommer: Risk Management and Insurance, 12e

Part 1 The Investment Process and Financial Concepts 1

Chapter 1 An Introduction to Investments 3

Chapter 2 The Creation of Financial Assets 28

Chapter 3 Securities Markets 49

Chapter 4 The Time Value of Money 83

Chapter 5 The Tax Environment 117

Chapter 6 Risk and Portfolio Management 145

Part 2 Investment Companies 209

Chapter 7 Investment Companies: Mutual Funds 211

Chapter 8 Closed-end Investment Companies 251

Part 3 Investing in Common Stock 269

Chapter 9 The Valuation of Common Stock 271

Chapter 10 Investment Returns and Aggregate Measures of Stock Markets 325

Chapter 11 Dividends: Past, Present, and Future 363

Chapter 12 The Macroeconomic Environment for Investment Decisions 390

Chapter 13 Analysis of Financial Statements 422

Chapter 14 Behavioral Finance and Technical Analysis 475

Part 4 Investing in Fixed-Income Securities 499

Chapter 15 The Bond Market 501

Chapter 16 The Valuation of Fixed-Income Securities 535

Chapter 17 Government Securities 596

Chapter 18 Convertible Bonds and Convertible Preferred Stock 644

Part 5 Derivatives 677

Chapter 19 An Introduction to Options 679

Chapter 20 Option Valuation and Strategies 721

Chapter 21 Commodity and Financial Futures 763

Part 6 Alternative Investments 801

Chapter 22 Investing in Foreign Securities 803

Chapter 23 Investing in Nonfinancial Assets: Collectibles, Natural Resources,

and Real Estate 831 Chapter 24 Portfolio Planning and Management in an Efficient Market Context 878

Part 1 The Investment Process and Financial Concepts 1

Chapter 1 An Introduction to Investments 3

Portfolio Construction and Planning 4Some Preliminary Definitions 5Sources of Risk 8

Diversification and Asset Allocation 11Efficient and Competitive Markets 12Portfolio Assessment 14

The Internet 15The Author’s Perspective and Investment Philosophy 16The Plan and Purpose of This Text 17

Appendix 1 22

Chapter 2 The Creation of Financial Assets 28

The Transfer of Funds to Business 29The Issuing and Selling of New Securities 31The Role of Financial Intermediaries 41Money Market Mutual Funds and Money Market Instruments 44

Chapter 3 Securities Markets 49

Secondary Markets and the Role of Market Makers 50The Mechanics of Investing in Securities 54

Foreign Securities 70Regulation 72Securities Investor Protection Corporation 77

Chapter 4 The Time Value of Money 83

The Future Value of $1 84The Present Value of $1 87The Future Sum of an Annuity 89The Present Value of an Annuity 92Illustrations of Compounding and Discounting 95Equations for the Interest Factors 100

Nonannual Compounding 101Uneven Cash Flows 103Time Value Problems and Spreadsheets 105

Contents

Chapter 5 The Tax Environment 117

Tax Bases 118Income Taxation 118Tax Shelters 120Life Insurance as a Tax Shelter 134Employee Stock Option Plans as a Tax Shelter 135Taxation of Wealth 137

Chapter 6 Risk and Portfolio Management 145

Return 146Sources of Risk 149The Measurement of Risk 154Risk Reduction through Diversification: An Illustration 163Portfolio Theory 167

The Capital Asset Pricing Model 171Beta Coefficients 174

Arbitrage Pricing Theory 183Appendix 6 195

Part 2 Investment Companies 209

Chapter 7 Investment Companies: Mutual Funds 211

Investment Companies: Origins and Terminology 211Mutual Funds 213

Selecting Mutual Funds 221Mutual Fund Returns 221Fees and Expenses 224Taxation 228

Risk-Adjusted Performance and the Importance of Benchmarks 236

Chapter 8 Closed-end Investment Companies 251

Closed-end Investment Companies 252Unit Trusts 256

Exchange-Traded Funds (ETFs) 257Asset Allocation 260

Part 3 Investing in Common Stock 269

Chapter 9 The Valuation of Common Stock 271

The Corporate Form of Business and the Rights of Common Stockholders 272Preemptive Rights 274

Investors’ Expected Return 275Valuation as the Present Value of Dividends and the Growth of Dividends 277

The Investor’s Required Return and Stock Valuation 283Alternative Valuation Techniques: Ratios That Combine Two Ratios 293The Efficient Market Hypothesis 298

Chapter 11 Dividends: Past, Present, and Future 363

Common Stock Cash Dividends 364Stock Dividends 369

The Stock Split 371Federal Income Taxes and Stock Dividends and Stock Splits 373Dividend Reinvestment Plans 373

Stock Repurchases and Liquidations 375Estimating Dividend Growth Rates 376Appendix 11 387

Chapter 12 The Macroeconomic Environment for Investment Decisions 390

The Logical Progression of Fundamental Analysis 391The Economic Environment 392

Measures of Economic Activity 393The Consumer Price Index 397The Federal Reserve 399Fiscal Policy 409

Industry Analysis 410The Anticipated Economic Environment and Investment Strategies 414

Chapter 13 Analysis of Financial Statements 422

Ratio Analysis 423Liquidity Ratios 424Activity Ratios 429Profitability Ratios 432Leverage or Capitalization Ratios 435Ratio Analysis for Specific Investors 441Analysis of Cash Flow 449

Fundamental Analysis in an Efficient Market Environment 455Appendix 13 468

Chapter 14 Behavioral Finance and Technical Analysis 475

Behavioral Finance 476The Purpose of the Technical Approach 481Market Indicators 482

Specific Stock Indicators 485The Verification of Technical Analysis 492

Part 4 Investing in Fixed-Income Securities 499

Chapter 15 The Bond Market 501

General Features of Bonds 502Risk 507

The Mechanics of Purchasing Bonds 511Variety of Corporate Bonds 513

High-Yield Securities 518Returns Earned by Investors in High-Yield Securities 522Retiring Debt 524

Appendix 15 533

Chapter 16 The Valuation of Fixed-Income Securities 535

Perpetual Securities 536Bonds with Maturity Dates 538Fluctuations in Bond Prices 542Yields 545

Risk and Fluctuations in Yields 551Realized Returns and the Reinvestment Assumption 554Duration 558

Bond Price Convexity and Duration 563

Management of Bond Portfolios 565Preferred Stock 569

Appendix 16A 590Appendix 16B 594

Chapter 17 Government Securities 596

The Variety of Federal Government Debt 597Federal Agencies’ Debt 606

State and Local Government Debt 614Taxable Municipal Securities 622Foreign Government Debt Securities 624Government Securities and Investment Companies 626Appendix 17 637

Chapter 18 Convertible Bonds and Convertible Preferred Stock 644

Features of Convertible Bonds 645The Valuation of Convertible Bonds 646Premiums Paid for Convertible Debt 652Convertible Preferred Stock 656

Selecting Convertibles 659The History of Selected Convertible Bonds 661Calling Convertibles 663

Put Bonds 664Bonds with Put and Call Features Compared 666Investment Companies and Convertible Securities 667

Part 5 Derivatives 677

Chapter 19 An Introduction to Options 679

Call Options 680Leverage 683Writing Calls 687Puts 692

Price Performance of Puts and Calls 700The Chicago Board Options Exchange 702Stock Index Options 704

Currency and Interest Rate Options 707Warrants 708

Rights Offerings 709

Chapter 20 Option Valuation and Strategies 721

Black-Scholes Option Valuation 721Expensing Employee Stock Options and Option Valuation 730Put–Call Parity 732

The Hedge Ratio 735Additional Option Strategies 738Buying the Call and a Treasury Bill Versus Buying the Stock—An Alternative to the Protective Put 749

Appendix 20 759

Chapter 21 Commodity and Financial Futures 763

What Is Investing in Commodity Futures? 764The Mechanics of Investing in Commodity Futures 764Leverage 770

Hedging 774The Selection of Commodity Futures Contracts 776Financial and Currency Futures 777

Stock Market Futures 780Programmed Trading and Index Arbitrage 783The Pricing of Futures 788

Swaps 790

Part 6 Alternative Investments 801

Chapter 22 Investing in Foreign Securities 803

The Global Economy 804The Special Considerations Associated with Foreign Investments 805Fluctuations in Exchange Rates 806

Balance of Payments 809Risk Reduction through Hedging with Currency Futures 814Advantages Offered by Foreign Securities 816

Emerging Markets 820Investment Companies with Foreign Investments 822

Chapter 23 Investing in Nonfinancial Assets: Collectibles, Natural Resources,

and Real Estate 831

Returns, Markets, and Risk 832Art and Other Collectibles 835Precious Metals and Natural Resources 839Real Estate 845

Hedge Funds and Private Equity Funds 867

Chapter 24 Portfolio Planning and Management in an Efficient Market

Context 878

The Process of Financial Planning 879Common Sense, Efficient Markets, and Investment Strategies 886

Appendix A 893Appendix B 899Glossary 909Index 917

Many individuals fi nd investments to be fascinating because they can actively ticipate in the decision-making process and see the results of their choices Of course, not all investments will be profi table because you will not always make correct invest-ment decisions Over a period of years, however, you should earn a positive return on

par-a diversifi ed portfolio In par-addition, there is the thrill from par-a mpar-ajor success, par-along with the agony associated with the stock that dramatically rose after you sold or did not buy Both the big fi sh you catch and the big fi sh that got away can make wonderful stories

Investing, of course, is not a game, but a serious subject that can have a major impact on your future well-being Virtually everyone makes investments Even if the individual does not select specifi c assets such as the stock of AT&T or federal gov-ernment Series EE bonds, investments are still made through participation in pension plans and employee savings programs or through the purchase of whole-life insurance

or a home Each of these investments has common characteristics, such as the tial return and the risk you must bear The future is uncertain, and you must deter-mine how much risk you are willing to bear, since a higher return is associated with accepting more risk

poten-You may fi nd investing daunting because of specialized jargon or having to work with sophisticated professionals A primary aim of this textbook is to make investing less diffi cult by explaining the terms, by elucidating the possible alternatives, and by discussing many of the techniques professionals use to value assets and to construct portfolios While this textbook cannot show you a shortcut to fi nancial wealth, it can reduce your chances of making uninformed investment decisions

This textbook uses a substantial number of examples and illustrations employing data that are generally available to the investing public This information is believed

to be accurate; however, you should not assume that mention of a specifi c fi rm and its securities is a recommendation to buy or sell those securities The examples have been chosen to illustrate specifi c points, not to pass judgment on individual investments.Many textbooks on investments are written for students with considerable back-ground in accounting, fi nance, and economics Not every student who takes a course

in investments has such a background These students cannot cope with (or be

ex-pected to cope with) the material in advanced textbooks on investments Investments:

An Introduction is directed at these students and covers investments from descriptive

material to the theory of portfolio construction and effi cient markets Some of the concepts (for example, portfolio theory) and some of the investment alternatives (for example, derivatives) are diffi cult to understand There is no shortcut to learning this material, but this text does assume that the student has a desire to tackle a fascinating subject and to devote real energy to the learning process

Individuals studying for the Certifi ed Financial Planner (CFP) professional

des-ignation also use Investments: An Introduction The investments section of the CFP

exam covers a broad range of topics While professionals studying for the exam may have covered some or even all of the topics in this text previously, they often need a

comprehensive review of investments For this reason, Investments: An Introduction

Preface

is comprehensive and includes material that some reviewers have suggested should be excluded Such exclusion, however, would result in topics on the CFP exam not being covered This extensive coverage does result in a long text that is diffi cult, perhaps im-possible, to complete during the traditional academic semester To meet the needs of instructors who are teaching a traditional semester course in investments, I have writ-

ten a more concise version of this text, Basic Investments.

CHANGES FROM THE PREVIOUS EDITION

Both reviewers and users have made suggestions for improving Investments: An

Introduction While I seriously considered every suggestion, the need to retain the

comprehensive nature of the text is paramount

This edition is divided into six instead of fi ve parts Part 1, Chapters 1 through 6,

is devoted to the investment process and basic fi nancial concepts such as the time value of money and the measurement of risk Part 2, Chapters 7 and 8, covers invest-ment companies, which were covered in one chapter in the previous edition Since both mutual funds and exchange-traded funds have grown in number and impor-tance, the coverage has been expanded into two chapters Exchange-traded funds also appear throughout the text

Part 3, chapters 9 through 14, covers investing in common stock, whereas Part 4, Chapters 15 through 18, covers fi xed income securities Chapters 19 through 21 (Part 5) are devoted to those fascinating speculative and hedging fi nancial assets referred to

as derivatives Part 6 adds foreign securities (Chapter 22) and alternative investments (Chapter 23) The text ends with an introduction to fi nancial planning in Chapter 24 Specifi c changes to the individual chapters are as follows

Although asset allocation appears throughout the text, it is introduced in ter 1 The chapter has a new Point of Interest on professional designations such as the CFA and the CFP The section in the previous edition on the similarities between in-vestments and corporate fi nance was deleted The investment project has also been re-placed with a case titled “The Investment Assignment,” which reappears several times through out the book (Internet assignments and problems have been added to several chapters, and they may be used as an alternative to the investment assignment.)The material on fi nancial intermediaries and money market mutual funds in Chapter 2 has been reduced Chapter 3 has a new Point of Interest on the pink sheets and additional problems Previously Chapter 4 was devoted to sources of informa-tion, While that chapter was been deleted, much of the contents appears throughout the text where in it is more appropriate and more useful

Chap-Chapter 4 is devoted to the time value of money, and a section on uneven cash

fl ows has been added Reviewers can never agree as to whether this material should

be in an investment text The two extremes are that time value has already been ered in previous classes and hence is redundant versus the position that you can never have too many time problems Many of the problems in this chapter illustrate invest-ment concepts such as valuation, the importance of retirement accounts, and the com-putation of returns

cov-While taxation affects investment decisions, the material in Chapter 5 on tion has been streamlined, and the section on corporate income taxation was deleted Chapter 6 on risk is essentially the same as in the previous addition except that asset

taxa-allocation has been integrated with diversifi cation The material on averages in the statistical appendix was deleted and integrated with the computation of indexes in Chapter 10.

The two chapters in Part 2 have been completely recast Chapter 7 is devoted solely to mutual funds and now includes material on the selection and redemption of funds that was previously in Chapter 24 Chapter 8 is devoted to closed-end and other investment companies with expanded coverage of exchange-traded funds This chap-ter includes asset allocation and the use of various types of investment companies to achieve a specifi ed asset allocation

Part 3 is devoted to investments in common stock Chapter 9 covers stock tion; the material on P/E ratios and other multiplier models has been expanded to in-clude ratios such as the price of the stock relative to the return on equity These mul-tiplier models are rarely covered in textbooks but are used by fi nancial analysts and portfolio managers to value stock Some of this material in Chapter 9 was previously

valua-in Chapter 13, and the reorganization reduces duplication

To meet reviewers’ requests, the coverage of various indexes in Chapter 10 has been expanded The calculation of averages and indexes has been reorganized, and the section of studies of investment returns has been tightened Chapter 11 on divi-dends remains one of the shortest chapters in the book The only substantive change was to increase coverage of stock repurchases Chapter 12 on the macro economy has been shortened

Reviewers’ comments on Chapter 13 on the analysis of fi nancial statements are similar to the comments on the time value of money Some reviewers believe their students have had suffi cient exposure, whereas others believe it is the heart of stock valuation and securities selection Placing some of the coverage with stock valuation

in Chapter 9 reduces the length of this chapter, but the chapter remains a thorough introduction to the analysis of fi nancial statements

One growing area in investments is behavioral fi nance While occasional ences to behavioral fi nance occur throughout the text, Chapter 14 starts with a new section of behavioral fi nance applied to investment decision making This discussion

refer-is followed by technical analysrefer-is Some of the previous coverage of technical tors has been cut or streamlined

indica-Part 4 on fi xed income securities and indica-Part 5 on derivatives are the least changed sections of the new edition Chapter 15, which describes the features of debt securi-ties, has a new, short discussion of the spread in yields between high- and low-quality debt Chapter 16 is a detailed discussion of bond valuation Several additional prob-lems have been added Chapter 17 on government securities is essentially unchanged except for the determination of mortgage payments, which has been transferred from Chapter 23 to Chapter 17 to help better explain the valuation of Ginnie Maes The only change in Chapter 18 on convertibles has been to streamline the chapter

Part 5 on derivatives begins with an introduction to puts and calls in Chapter 19 Chapter 20 covers option strategies and valuation with emphasis on the Black-Scholes option valuation model Chapter 21 is devoted to futures contracts Other than addi-tional problems and selected rewriting, these chapters are essentially unchanged Part 6 is devoted to alternative investments Chapter 22 encompasses foreign in-vestments with additional material on foreign indexes, globalization, and the possible reduction in the benefi ts of diversifi cation through foreign investments Chapter 23 is

a long chapter that encompasses collectibles, real assets such a timber and gold, real estate, and hedge funds The chapter is structured so that each section is indepen-dent of the other Coverage of hedge and private-equity funds, which have received

so much attention in the fi nancial press, has been added Chapter 24 is a brief duction to fi nancial planning Material in the previous edition that applies to specifi c types of assets has been allocated to other sections of the text The remaining sections

intro-of this chapter stress specifying fi nancial goals, constructing an individual’s fi cial statements, and developing fi nancial strategies to achieve fi nancial objectives The text ends with a reminder that fi nancial plans and the allocation of assets occur in ef-

nan-fi cient nan-fi nancial markets

The previous edition had an “investment project,” which required students to set

up watch accounts and follow how the stocks performed during the semester In this edition, the investment project has been recast as a case titled “The Investment As-signment.” It is essentially a buy-and-hold strategy and not a trading game I have some reluctance to use this type of pedagogical tool, since my personal investment goals and strategies have a longer time dimension than a semester I want students to develop a longer time horizon for investing and to realize the importance of diversi-

fi cation and not to chase the latest investment fad or the latest hot stock However, even though the investment project and the revised cases have major drawbacks, they may be used to illustrate diversifi cation, market risk, and the tendency for a portfolio

to follow the market

One potentially useful feature on the Web site is the Investment Analysis culator, which can perform many of the calculations used in this text and help solve end-of-chapter problems An instructor can easily create additional problems that are readily solved by the calculator but might be unreasonable if the student had to per-form many calculations For example, if an instructor wanted to illustrate the impact

Cal-on the price of a bCal-ond from many changes in the interest rate, the investment analysis calculator facilitates the calculations so the instructor may spend time using and ex-plaining the results

PEDAGOGICAL FEATURES

This textbook has a variety of features designed to assist the student in the learning process Each chapter starts with a set of learning objectives These point out topics to look for as the chapter develops Terms to remember are defi ned in the marginal glos-sary that appears as each term is introduced in the text Chapters also include ques-tions and, where appropriate, problems The questions and problems are straightfor-ward and designed primarily to review the material Answers to selected problems are provided in Appendix B

This edition retains the short cases These are not cases in the general usage of the term, in which a situation is presented and the student is required to determine the appropriate questions and formulate an answer or strategy The cases in this text-book are essentially problems that are cast in real-world situations For example, a case may ask how much an individual would lose following one investment strategy instead of an alternative when either could be appropriate to meet a specifi c fi nancial goal Thus, the primary purpose of the cases is to help illustrate how the material may apply in the context of real investment decisions

Time value of money problems permeate this text While the use of interest tables

is an excellent means to teach and illustrate time value problems, many students have

fi nancial calculators Time value calculations using a fi nancial calculator are placed in the margin to avoid breaking the fl ow of the text material

Many instructors have their students construct a paper portfolio An Investment Assignment case is included, which is essentially a buy-and-hold strategy There are also interesting points that may not fi t neatly into a particular chapter To include these, I have added boxed Point of Interest features to the chapters These boxes may amplify the text material or present new material to supplement the coverage in the text The tone of the Point of Interest features is often lighter than the text and is de-signed to increase reader interest in the chapter as a whole

ExamView

This computerized testing software contains all of the questions in the printed Test Bank ExamView is easy-to-use test creation software that is compatible with both Microsoft Windows and Macintosh Instructors can add or edit questions, instruc-tions, and answers and select questions by previewing them on the screen, selecting them randomly, or selecting them by number

ThomsonNOW: A New Web-Based Course Management Platform

ThomsonNOW is a Web-based course management system It can be seamlessly tegrated into Blackboard and WebCT for those instructors already using those Web-based course management systems ThomsonNOW includes the following features, with more to be added over time:

in-The Courseware Individualized Learning Plan For each chapter, a student can take a “pre-test” in the Courseware section of ThomsonNOW This pre-test is auto-matically scored, and the student is given a learning plan that identifi es the chapter’s sections on which the student needs to improve This learning plan has links to an

e-book and other learning objects for each topic, so a student can also read and study the material without leaving the computer In addition, a “post-test” helps the student determine if he or she has mastered the material.

Homework Assignments with Automatic Grading As previously noted, sonNOW includes select end-of-chapter and Test Bank problems With just a few clicks, an instructor can create a Web-based homework assignment that contains unique problems and answers for each student The assignment is automatically graded, and the scores are posted to a gradesheet that can be exported into Excel or into the gradesheets of Blackboard and WebCT Similarly, an instructor can create sets of practice problems (based on the end-of-chapter problems and Test Bank prob-lems) In Finance, practice makes perfect, so ThomsonNOW’s ability to quickly and easily create practice problems and grade homework assignments can have a dramatic impact on a student’s progress and knowledge

Thom-e-Book ThomsonNOW also contains an e-book, which is very helpful to students who use the Individualized Learning Plan in ThomsonNOW’s Courseware—they can read the e-book and work practice problems without ever leaving the computer

Investment Analysis Calculator

This browser-based tool found on the book’s Web site is designed to accompany the book and is free to adopters of the text It includes numerous routines that may be used to help solve end-of-chapter problems The software is menu driven and is a use-ful tool for solving complex problems Please note that it is not designed as a substi-tute for understanding the mechanics of problem analysis and solution Thus, while the Investment Analysis Calculator may help determine a stock’s value, it cannot an-swer the question of whether or not the stock should be bought or sold; such a judg-ment must come from the user of the Investment Analysis Calculator

PowerPoint™ Slides

These are available on the Web site and on the Instructor’s Resource CD-ROM for use by instructors for enhancing their lectures These slides bring out the most im-portant points in the chapter They also include important charts and graphs from the text, which will aid students in the comprehension of signifi cant concepts This edition’s slide package has been revised by Anne Piotrowski

Instructor’s Resource CD-ROM

Get quick access to all instructor ancillaries from your desktop This easy-to-use CD-ROM lets you review, edit, and copy exactly what you need in the format you want The Instructor’s Resource CD-ROM contains electronic versions of the In-structor’s Manual, the Test Bank, the resource PowerPoint presentation, and the ExamView fi les

Web Site

The support Web site for Investments: An Introduction, Ninth Edition (http://www thomsonedu.com/mayo) includes the following features:

Instructor ResourcesInternet Applications

•

•

Student ResourcesCaseNet

NewsWire: Finance in the NewsInvestment Analysis CalculatorTalk to Us

About the Product

POSSIBLE ORGANIZATIONS OF INVESTMENT COURSES

The textbook has 24 chapters, but few instructors are able to complete the entire book in a semester course Many of the chapters are self-contained units, so indi-vidual chapters may be omitted (or transposed) without loss of continuity There are, however, exceptions For example, the valuation of bonds uses the material on the time value of money The valuation of common stock employs much of the material covered in the chapter on risk

Part 1 covers investment fundamentals It includes how securities come into istence and the role of fi nancial intermediaries (Chapter 2); how securities are traded (Chapter 3); and risk, its measurement, and portfolio management (Chapter 7) These chapters are not easily omitted Other chapters in Part 1 could be omitted if the stu-dents have covered the material in other courses (for example, the time value of money

ex-in Chapter 5 and taxation ex-in Chapter 6)

The bread and butter of investing in fi nancial assets is the analysis and selection

of common stocks (Part 2) and fi xed income securities (Part 3) Virtually all of this material should be covered in class with the possible exceptions of the material on technical analysis, high-yield securities, and convertibles

The remaining parts of this text leave the individual instructor considerable choice Since each instructor has personal preferences, any of the remaining eight chapters is easily omitted or included depending on the availability of time My personal prefer-ence is to include the basic material on options (Chapter 19), which many students

fi nd both diffi cult and exciting, and the material on fi nancial planning (Chapter 24),

as the latter serves as a means to tie the course together

ACKNOWLEDGMENTS

A textbook requires the input and assistance of many individuals in addition to its thor Over the years, my publisher has provided thoughtful reviews from individuals who sincerely offered suggestions for improvement Unfortunately, suggestions some-times are contradictory Since an author cannot please all of the reviewers at the same time, I trust that individuals whose advice was not (or could not be) taken will not be offended

au-The following individuals provided valuable suggestions for improving the ninth edition These include:

Mark G Castelino, Rutgers UniversityWilliam Compton, University of North Carolina–WilmingtonMichael Evans, Winthrop University

Richard D Gritta, University of PortlandGary D Koppenhaver, Iowa State University

Gregory Koutmos, Fairfi eld UniversitySeyed Mehdian, University of Michigan–FlintMark Minbiole, Northwood UniversityMichael G Nugent, State University of New York–Stony BrookRose Prasad, Central Michigan University

Larry Prather, Southeast Oklahoma State UniversityPaul Swanson, University of Cincinnati

William Trainor, Western Kentucky UniversityJoe Walker, University of Alabama–BirminghamZhong-guo Zhou, California State University, Northridge

In addition to academic reviewers, I have received considerable help from Andy Carver (The College of New Jersey), George A Jouganatos (University of California– Davis), Frank Heiner (Scott & Stringfellow), Leo Kelly III (Merrill Lynch), and Robert Witter-schein (Bloomberg) My former developmental editor, Trish Taylor, was an important sounding board and coach during the revisions All of these individuals graciously provided me with information and examples that have found their way into the text Ron Meier who was with the College for Financial Planning offered advice concern-ing text coverage and the CFP examination He was particularly helpful about what needed to be added and what could be deleted

Anne Piotrowski created the PowerPoint slides Her willingness to work through various styles and possible presentations greatly enhanced the fi nal product She de-serves a special “thank you” for her efforts

At this point, it is traditional for the author to thank members of the editorial and production staff for their help in bringing the book to fruition I wish to thank Mike Reynolds, my editor; Jason Krall, my marketing manager; Tammy Moore, my pro-duction editor; and Matt McKinney, my technology project manager I want to ex-tend a special thanks to my senior developmental editor, Susan Smart, for facilitating the completion of the text

The Investment Process

and Financial Concepts

Investing is a process by which individuals

con-struct a portfolio of assets designed to meet

specifi ed fi nancial goals These goals range from

fi nancing retirement or paying for a child’s

edu-cation to starting a business and having funds to

meet fi nancial emergencies The specifi cation of fi

-nancial goals is important, for they help determine

the appropriateness of the assets acquired for the

portfolio

Part 1 of this text covers the mechanics of

buy-ing and sellbuy-ing fi nancial assets, the legal and tax

environment in which investment decisions are

made, and crucial fi nancial concepts that apply

to asset allocation and portfolio management

Chapter 1 introduces important defi nitions and

concepts that appear throughout the text

Chap-ters 2 and 3 are devoted to the mechanics of

in-vesting These include the process by which

se-curities are issued (Chapter 2) and subsequently

bought and sold (Chapter 3) Next follows one of

the most important concepts in fi nance, the time

value of money (Chapter 4) All investments are

made in the present but returns occur in the

fu-ture Linking the future and the present is the

es-sence of the time value of money Chapter 5

cov-ers taxation Tax rates differ on different sources

of income; some investments and strategies defer tax obligations, and others avoid taxation These differences in taxation affect the amount of the re-turn you earn that you get to keep In addition,

at least some facet of the tax law changes each year, which complicates investment decision mak-ing and affects investment strategy

Since the future is not known, all investments involve risk Chapter 6 is devoted to sources of risk, how risk may be measured, and how it may

be managed The allocation of your assets and the construction of a diversifi ed portfolio may be the most important fi nancial concept you must face Failure to diversify subjects the investor to addi-tional risk without generating additional return Your objective should be to construct a portfolio that maximizes your return for a given level of risk

Of course, this requires that you determine how much risk you are willing to bear Individuals with different fi nancial resources and disparate fi nan-cial goals may be willing to accept different levels

of risk, but in each case the goal is to maximize the return for the amount of risk the investor bears One fi nal caveat before you start Part 1: in-vestments are made in exceedingly competitive markets Rapid dissemination of information and

stiff competition among investors produce effi cient markets Effi cient markets imply that you cannot expect to earn abnormally high returns over an extended period of time Although you may outperform the market, such performance on a consistent basis is rare Perhaps you will do exceptionally well, but then there is also the chance of doing exceptionally poorly The emphasis in this text will be not how to outperform but how

to use fi nancial assets to meet fi nancial goals That is, you should emphasize ing a diversifi ed portfolio that meets your fi nancial objectives and earns a return that compensates you for the risk you take

construct-An Introduction to Investments

In 1986, Microsoft fi rst sold its stock to the general

public Within ten years, the stock’s value had

in-creased by over 5,000 percent A $10,000

invest-ment was worth over $500,000 In the same year,

Worlds of Wonder also sold its stock to the

pub-lic Ten years later, the company was defunct A

$10,000 investment was worth nothing These are

two examples of emerging fi rms that could do well or

could fail Would investing in large, well-established

companies generate more consistent returns? The

answer depends, of course, on which stocks were

purchased and when In 1972, Xerox stock reached

a high of $171.87 a share The price subsequently

declined and did not exceed the old high for the

next 26 years Now it languishes way below that

his-toric high

Today the investment environment is even more

dynamic World events can rapidly alter the values

of specifi c assets There are so many assets from

which to choose The amount of information

avail-able to investors is staggering and grows

continu-ally The accessibility of personal computers and the dissemination of information on the Internet increase

an individual’s ability to track investments and to perform investment analysis Furthermore, the reces-sions of the early 1990s and 2000s, the large de-cline in stock prices during 2000–2002, the historic decline in interest rates during 2001–2003, and the frequent changes in the tax laws have increased investor awareness of the importance of fi nancial planning, asset selection and allocation, and port-folio construction

This text will describe and explain many ment alternatives and strategies But a textbook can-not make investment decisions for you; it can only provide information about your choices This text ex-plains techniques for analyzing and valuing fi nan-cial assets, their sources of risk, and how these risks may be managed, if not eliminated It is your obli-gation to learn the material, determine which parts are most relevant, and then apply them to your fi -nancial situation

invest-After completing this chapter you should be

able to:

Explain why individuals should specify

invest-ment goals

Distinguish between primary and secondary

markets, risk and speculation, liquidity and

PORTFOLIO CONSTRUCTION AND PLANNING

Investment decisions are about making choices: Will income be spent or saved? If you choose to save, you face a second decision: What should be done with the savings? Each saver must decide where to invest this command over resources (goods and ser-vices) that is currently not being used This is an important decision because these as-sets are the means by which investors transfer today’s purchasing power to the future

In effect, you must decide on a portfolio of assets to own (Terms will be in boldface and defi ned in the margin.) A portfolio is simply a combination of assets designed to serve as a store of value Poor management of these assets may destroy the portfolio’s value, and you will then not achieve your fi nancial goals

There are many assets (e.g., stocks, bonds, derivatives) that you may include

in the portfolio This textbook will discuss many of them, but the stress will be on long-term fi nancial assets While you may hold a portion of the portfolio in short-term assets, such as savings accounts, these assets do not seem to present the prob-lem of valuation and choice that accompanies the decision to purchase a stock or a bond Understanding how long-term securities are bought and sold, how they are valued, and how they may be used in portfolio construction is the primary focus of this text

Several factors affect the construction of a portfolio These include the goals of the investor, the risks involved, the taxes that will be imposed on any gain, and a knowledge of the available opportunities and alternative investments This text will cover the range of these alternative investments, their use in a portfolio, the risks as-sociated with owning them, and their valuation

The investor’s goals should largely determine the construction and management

of the portfolio Investing must have a purpose, for without a goal a portfolio is like a boat without a rudder Some objective must guide the composition of the portfolio.There are many reasons for saving and accumulating assets Individuals may post-pone current consumption to accumulate funds to make the down payment on a house,

fi nance a child’s education, start a business, meet fi nancial emergencies, fi nance ment, leave a sizable estate, or even accumulate for the sake of accumulating For any

retire-or all of these reasons, people construct pretire-ortfolios rather than spend all their current income

The motives for saving should dictate, or at least affect, the composition of the portfolio Not all assets are appropriate to meet the investor’s fi nancial goals For example, savings that are held to meet emergencies, such as an extended illness or un-employment, should not be invested in assets whose return and safety of principal are uncertain Instead, emphasis should be placed on safety of principal and assets that may be readily converted into cash, such as savings accounts or shares in money mar-ket mutual funds The emphasis should not be on growth and high returns However, the funds should not sit idle but should be invested in relatively safe assets that offer

a modest return

Other goals, such as fi nancing retirement or a child’s education, have a longer and more certain time horizon The investor knows approximately when the funds will be needed and so can construct a portfolio with a long-term horizon Bonds that mature when the funds will be needed or common stocks that offer the potential for growth would be more appropriate than savings accounts or certifi cates of deposit The lon-

ger time period means the individual can acquire long-term assets that may offer a higher yield.

Most investors have several fi nancial goals that must be met simultaneously Thus, it is not surprising to learn that their portfolios contain a variety of assets Of course, priorities and needs differ The individual who is employed in a cyclical indus-try and may be laid off during a recession may place more stress on funds to cover unemployment than would the tenured professor An individual with a poor medi-cal history may seek to have more short-term investments than the person with good health Medical coverage or disability insurance will also affect the individual’s need for funds to cover a short-term emergency If the investor has this coverage, more of the portfolio may be directed toward other fi nancial goals

In addition to the individual’s goals, willingness to bear risk plays an important role in constructing the portfolio Some individuals are more able to bear (that is, assume) risk These persons will tend to select assets on which the return involves greater risk to obtain the specifi ed investment goals For example, if the saver wants

to build a retirement fund, he or she can choose from a variety of possible ments However, not all investments are equal with regard to risk and potential re-turn Those investors who are more willing to accept risk may construct portfolios with assets involving greater risk that may earn higher returns

invest-Taxes may also affect the composition of an individual’s portfolio Income such

as interest and realized capital gains are taxed When a person dies, the federal ernment taxes the value of the estate, and many states levy a tax on an individual’s inheritance Such taxes and the desire to reduce them affect the composition of each investor’s portfolio

gov-Portfolio decisions are obviously important They set a general framework for the asset allocation of the portfolio among various types of investments Individuals, how-ever, rarely construct a portfolio all at once but acquire assets one at a time The decision revolves around which specifi c asset to purchase: Which mutual fund? Which bond? or Which stock? Security analysis considers the merits of the individual asset Portfolio management determines the impact that the specifi c asset has on the portfolio

A large portion of this text is devoted to descriptions and analysis of individual securities, because it is impossible to know an asset’s effect on the portfolio without

fi rst knowing its characteristics Stocks and bonds differ with regard to risk, potential return, and valuation Even within a type of asset such as bonds there can be consid-erable variation For example, a corporate bond is different from a municipal bond, and a convertible bond differs from a straight bond that lacks the conversion feature The investor needs to know and to understand these differences as well as the relative merits and risks associated with each of the assets After understanding how individ-ual assets are valued, the investor may then construct a portfolio that will aid in the realization of his or her fi nancial goals

SOME PRELIMINARY DEFINITIONS

I went to the doctor and he said, “You have a contusion.” I asked, “What is a sion?” and he said, “A bruise.” I thought: “A bruise by another name is still a bruise” and immediately wanted to ask (but did not), “Why not call it a bruise?”

contu-Every discipline or profession has its own terminology The fi eld of investments

is no different Some of the jargon is colorful (e.g., bull and bear); some is descriptive (e.g., primary and secondary markets); and some, like contusion, seems to confuse or muddy the waters (e.g., purchasing power risk, which is the risk associated with loss

from infl ation) In order to proceed, it is desirable to know some initial defi nitions cerning investments, and the best time to learn them and to start using them is now.The term investment can have more than one meaning In economics, it refers to the purchase of a physical asset, such as a fi rm’s acquisition of a plant, equipment, or inventory or an individual’s purchase of a new home To the layperson the word de-notes buying stocks or bonds (or maybe even a house), but it probably does not mean purchasing a plant, equipment, or inventory

con-In either case, the fi rm or the individual wants a productive asset The difference

in defi nition rests upon the aggregate change in productive assets that results from the investment When fi rms invest in plant and equipment, there is a net increase in productive assets This increase generally does not occur when individuals purchase

stocks and bonds Instead, for every investment by the buyer there is an equal

dis-investment by the seller These buyers and sellers are trading one asset for another: The seller trades the security for cash, and the buyer trades cash for the security These transactions occur in secondhand markets, and for that reason securities mar-kets are often referred to as secondary markets Only when the securities are initially issued and sold in the primary market is there an investment in an economic sense Then and only then does the fi rm receive the money that it, in turn, may use to pur-chase a plant, equipment, or inventory

In this text, the word investment is used in the layperson’s sense Purchase of an

asset for the purpose of storing value (and, it is hoped, increasing that value over time) will be called an investment, even if in the aggregate there is only a transfer of own-ership from a seller to a buyer The purchases of stocks, bonds, options, commodity contracts, and even antiques, stamps, and real estate are all considered to be invest-ments if the individual’s intent is to transfer purchasing power to the future If these assets are acting as stores of value, they are investments for that individual

Assets have value because of the future benefi ts they offer The process of mining what an asset is worth today is called valuation An investor appraises the asset and assigns a current value to it based on the belief that the asset will generate cash fl ows (e.g., interest) or will appreciate in price After computing this value, the individual compares it with the current market price to determine if the asset is cur-rently overpriced or underpriced

deter-In some cases this valuation is relatively easy For example, the bonds of the eral government pay a fi xed amount of interest each year and mature at a specifi ed date Thus, the future cash fl ows are known However, the future cash fl ows of other assets are not so readily identifi ed For example, although you may anticipate future dividends, neither their payment nor their amount can be known with certainty Fore-

fed-casting future benefi ts may be diffi cult, but it is still crucial to the process of

valua-tion Without forecasts and an evaluation of the asset, you cannot know if the asset

should be purchased or sold

Because the valuation of some assets is complicated and the future is uncertain, people may have different estimates of the future cash fl ows It is therefore easy to under stand why two individuals may have completely divergent views on the worth of

a particular asset One person may believe that an asset is overvalued and hence seek

to sell it, while another may seek to buy it in the belief that it is undervalued tion may be subjective, which leads to one person’s buying while the other is selling That does not mean that one person is necessarily irrational or incompetent People’s perceptions or estimates of an asset’s potential may change, affecting their valuation

Valua-of the specifi c asset

An investment is made because the investor anticipates a return The total return

on an investment is what the investor earns This may be in the form of income, such

as dividends and interest, or in the form of capital gains, or appreciation if the asset’s price rises Not all assets offer both income and capital appreciation Some stocks pay

no current dividends but may appreciate in value Other assets, including savings counts, do not appreciate in value The return is solely the interest income

ac-Return is frequently expressed in percentages, such as the rate of return, which

is the annualized return that is earned by the investment relative to its cost Before purchasing an asset, the investor anticipates that the return will be greater than that

of other assets of similar risk Without this anticipation, the purchase would not be

made The realized return may, of course, be quite different from the anticipated rate

of return That is the element of risk

Risk is the uncertainty that the anticipated return will be achieved As is discussed

in the next section, there are many sources of risk The investor must be willing to bear this risk to achieve the expected return Even relatively safe investments involve some risk; there is no completely safe investment For example, savings accounts that are insured still involve some element of risk of loss If the rate of infl ation exceeds the rate of interest that is earned on these insured accounts, the investor suffers a loss of purchasing power

The term risk has a negative connotation, but uncertainty works both ways For

example, events may occur that cause the value of an asset to rise more than ticipated Certainly the stockholders of Rubbermaid reaped returns that were larger than had been anticipated when it was announced the fi rm would merge with Newell The price paid for the stock was considerably higher than the price the security com-manded before the announcement of the merger

an-A term that is frequently used in conjunction with risk is speculation Many years ago virtually all investments were called “speculations.” Today the word implies a high degree of risk However, risk is not synonymous with speculation Speculation has the connotation of gambling, in which the odds are against the player Many securities are risky, but over a period of years the investor should earn a positive return The odds are not really against the investor, and such investments are not speculations

The term speculation is rarely used in this text, and when it is employed, the

implication is that the individual runs a good chance of losing the funds invested

in the speculative asset Although a particular speculation may pay off somely, the investor should not expect that many such gambles will reap large returns After the investor adjusts for the larger amount of risk that must be borne to own such speculative investments, the anticipated return may not justify the risk involved.Besides involving risk and offering an expected return, stores of value have mar-ketability or liquidity These terms are sometimes used interchangeably, but they may also have different defi nitions Marketability implies that the asset can be bought and sold Many fi nancial assets, such as the stock of AT&T, are readily marketable

hand-return

The sum of income

plus capital gains

large return but

is also very risky;

The ease with which an asset may be converted into money is its liquidity

Un-fortunately, the word liquidity is ambiguous In academic writings on investments quidity usually means ease of converting an asset into cash without loss A savings ac-

li-count with a commercial bank is liquid, but shares of IBM would not be liquid, since you could sustain a loss In professional writings, liquidity usually means ability to

sell an asset without affecting its price In that context, liquidity refers to the depth

of the market for the asset You may be able to buy or sell 1,000 shares of IBM stock without affecting its price, in which case the stock is liquid The context in which the word is used often indicates the specifi c meaning

All assets that serve as stores of value possess some combination of marketability, liquidity, and the potential to generate future cash fl ow or appreciate in price These features, along with the risk associated with each asset, should be considered when including the asset in an individual’s portfolio Since assets differ with regard to their features, you need to know the characteristics of each asset Much of the balance of this text describes each asset’s features as well as its sources of risk and return and how it may be used in a well-diversifi ed portfolio

SOURCES OF RISK

Risk refers to the uncertainty that the actual return the investor realizes will differ from the expected return As is illustrated in Exhibit 1.1, the sources of this variabil-ity in returns is often differentiated into two types of risk: systematic and unsystem-atic risk Systematic risk refers to those factors that affect the returns on all compa-rable investments For example, when the market as a whole rises, the prices of most individual securities also rise There is a systematic relationship between the return

on a specifi c asset and the return on all other assets in its class (i.e., all other rable assets) Because this systematic relationship exists, diversifying the portfolio by acquiring comparable assets does not reduce this source of risk; thus, systematic risk

compa-is often referred to as nondiversifi able rcompa-isk While constructing a diversifi ed portfolio

has little impact on systematic risk, you should not conclude that this nondiversifi able risk cannot be managed One of the objectives of this text is to explain a variety of techniques that help manage the various sources of systematic risk

EXHIBIT 1.1 The Sources of Risk

Total Risk

Unsystematic Risk (diversifiable)

Business Risk

Financial Risk

Systematic Risk (nondiversifiable)

Market Risk

Interest Rate Risk

Reinvestment Rate Risk

Purchasing Power Risk

Exchange Rate Risk

Unsystematic risk, which is also referred to as diversifi able risk, depends on

fac-tors that are unique to the specifi c asset For example, a fi rm’s earnings may decline because of a strike Other fi rms in the industry may not experience the same labor problem, and thus their earnings may not be hurt or may even rise as customers di-vert purchases from the fi rm whose operations are temporarily halted In either case, the change in the fi rm’s earnings is independent of factors that affect the industry, the market, or the economy in general Because this source of risk applies only to the spe-cifi c fi rm, it may be reduced through the construction of a diversifi ed portfolio.The total risk the investor bears consists of unsystematic and systematic risk The sources of unsystematic risk may be subdivided into two general classifi cations: busi-ness risk and fi nancial risk The sources of systematic risk may be subdivided into market risk, interest rate risk, reinvestment rate risk, purchasing power risk, and ex-change rate risk

Business risk is the risk associated with the nature of the enterprise itself Not all businesses are equally risky Drilling for new oil deposits is more risky than running a commercial bank The chances of fi nding oil may be slim, and only one of many new wells may actually produce oil and earn a positive return Commercial banks, how-ever, can make loans that are secured by particular assets, such as residences or inven-tories While these loans are not risk-free, they may be relatively safe because even if the debtor defaults, the creditor (the bank) can seize the asset to meet its claims Some businesses are by their very nature riskier than others, and, therefore, investing in them is inherently riskier

All assets must be fi nanced Either creditors or owners or both provide the funds

to start and to sustain the business Firms use debt fi nancing for two primary reasons First, under current tax laws interest is a tax-deductible expense while dividends paid

to stockholders from earnings are not Second, debt fi nancing is a source of fi nancial leverage that may increase the return on equity (i.e., the return to the owners) If the

fi rm earns more on the borrowed funds than it must pay in interest, the return on equity is increased

For many fi rms the use of debt fi nancing is a major source of funds Leveraged buyouts and corporate restructuring often involve the issuing of a substantial amount

of debt and have led to the development of high-yield securities often called junk

bonds Even conservatively managed fi rms use debt fi nancing Virtually every fi rm

has some debt outstanding even if the debt is limited to accrued wages and accounts payable generated by the normal course of business

This use of fi nancial leverage is the source of fi nancial risk Borrowing funds to

fi nance a business may increase risk, because creditors require that the borrower meet certain terms to obtain the funds The most common of these requirements is the pay-ing of interest and the repayment of principal The creditor can (and usually does) de-mand additional terms, such as collateral or restrictions on dividend payments, that the borrower must meet These restrictions mean that the fi rm that uses debt fi nanc-ing bears more risk because it must meet these obligations in addition to its other ob-ligations When sales and earnings are rising, these constraints may not be burden-some, but during periods of fi nancial stress the failure of the fi rm to meet these terms may result in fi nancial ruin and bankruptcy A fi rm that does not use borrowed funds

to acquire its assets does not have these additional responsibilities and does not have the element of fi nancial risk

The risk associated

with the nature of a

Market risk refers to the tendency of security prices to move together While it may be frustrating to invest in a fi rm that appears to have a minimum amount of business risk and fi nancial risk and then to watch the price of its securities fall as the market as a whole declines, that is the nature of market risk Security prices do fl uctu-ate, and the investor must either accept the risk associated with those fl uctuations or not participate in the market.

While market risk is generally applied to stocks, the concept also applies to other assets, such as precious metals and real estate The prices of these assets fl uctuate If the value of houses were to rise in general, then the value of a particular house would also tend to increase But the converse is also true because the prices of houses could decline, causing the value of a specifi c house to fall Market risk cannot be avoided if you acquire assets whose prices may fl uctuate

Interest rate risk refers to the tendency of security prices, especially fi xed-income securities, to move inversely with changes in the rate of interest As is explained in de-tail in Chapter 16, the prices of bonds and preferred stock depend in part on the cur-rent rate of interest Rising interest rates decrease the current price of fi xed-income securities because current purchasers require a competitive yield The investor who acquires these securities must face the uncertainty of fl uctuating interest rates that, in turn, cause the price of these fi xed-income securities to fl uctuate

Reinvestment rate risk refers to the risk associated with reinvesting funds erated by an investment If an individual receives interest or dividends, these funds could be spent on goods and services For example, many individuals who live on a pension consume a substantial portion, and perhaps all, of the income generated by their assets Other investors, however, reinvest their investment earnings in order to accumulate wealth

gen-Consider an individual who wants to accumulate a sum of money and purchases

a $1,000 bond that pays $100 a year and matures after ten years The anticipated annual return based on the annual interest and the amount invested is 10 percent ($100/$1,000) The investor wants to reinvest the annual interest, and the question then becomes what rate will be earned on these reinvested funds: Will the return be more or less than the 10 percent initially earned? The essence of reinvestment rate risk

is the uncertainty that the investor will earn less than the anticipated return when payments are received and reinvested

In addition to the previously mentioned risks, the investor must also bear the risk associated with infl ation Infl ation is the loss of purchasing power through a general rise in prices If prices of goods and services increase, the real purchasing power of the investor’s assets and the income generated by them is reduced Thus, purchasing power risk is the risk that infl ation will erode the buying power of the investor’s assets and income The opposite of infl ation is defl ation, which is a general decline in prices During a period of defl ation, the real purchasing power of the investor’s assets and in-come is increased

Investors will naturally seek to protect themselves from loss of purchasing power

by constructing a portfolio of assets with an anticipated return that is higher than the

anticipated rate of infl ation It is important to note the word anticipated, because it

infl uences the selection of particular assets If infl ation is expected to be 4 percent, a savings account offering 6 percent will produce a gain and thereby “beat” infl ation However, if the infl ation rate were to increase unexpectedly to 7 percent, the savings

market risk

Systematic risk;

the risk associated

with the tendency

rates; the possibility

of loss resulting from

that future infl ation

will erode the

purchasing power of

assets and income.

account would result in a loss of purchasing power The real rate of return is negative

If the higher rate of infl ation had been expected, the investor might not have chosen the savings account but might have purchased some other asset with a higher poten-tial return

The last source of systematic risk in Exhibit 1.1 is exchange rate risk, which is the uncertainty of the value of a currency that occurs when one currency is converted into another This source of risk applies only if the investor acquires foreign assets de-nominated in a foreign currency Avoiding such assets means the investor avoids this source of risk However, because the individual may acquire shares in domestic fi rms with foreign operations or shares in mutual funds that make foreign investments, the individual still may indirectly bear exchange rate risk

If the investor bears more risk, he or she may earn a higher return This is the sential trade-off that all investors must face Federally insured savings accounts offer lower yields but are less risky than bonds issued by AT&T, and AT&T bonds are less risky than the stock of a small, emerging fi rm whose securities are traded over the counter

es-In addition to the sources already covered, there are at least two sources of risk,

“event” risk and “country or political” risk, that are not readily classifi ed as atic or unsystematic “Event” risk applies to an unanticipated event such as a major storm A hurricane such as Katrina could affect a specifi c fi rm, so the impact could

system-be diversifi ed away But the hurricane could affect a sector or a region, in which case the impact is not so easily diversifi ed away “Country” risk refers to political actions such as the fall of a government or the outbreak of hostilities Diversifi cation will re-duce the impact of country-specifi c problems, but if the scope of the political event is broad, diversifi cation cannot erase this source of risk

By now it should be obvious that all investors bear risk Even an investor who does nothing cannot avoid risk By “doing nothing” and holding cash or placing the funds in a savings account, the investor is still making an investment and is bearing some element of risk The very nature of transferring purchasing power from today to tomorrow requires accepting some risk, because the future is uncertain Risk simply cannot be avoided, as any choice will involve at least one of the sources of risk: busi-ness risk, fi nancial risk, market risk, interest rate risk, reinvestment rate risk, purchas-ing power risk, and exchange rate risk

DIVERSIFICATION AND ASSET ALLOCATION

The previous section indicates that the impact of asset-specifi c risk may be diversifi ed away As is explained in detail in Chapter 6, to achieve diversifi cation the returns on your investments must not be highly correlated Factors that negatively affect one se-curity must have a positive impact on others For example, higher oil prices may be good for ExxonMobil but bad for Delta Airlines By combining a variety of disparate assets, you achieve diversifi cation and reduce unsystematic risk

Asset allocation refers to acquiring a wide spectrum of assets Individuals use their fi nite resources to acquire various types of assets that include stocks, bonds, pre-cious metals, collectibles, and real estate Even within a class such as stocks, the port-folio is allocated to different sectors or regions For example, you may own domestic

exchange rate risk

stocks and stocks of companies in emerging nations It would appear that “asset location” and “diversifi cation” are synonymous, and to some extent they are By allo-cating your assets over different types of assets you contribute to the diversifi cation of the portfolio But asset allocation and diversifi cation are often used in different con-texts For example, you may tilt your allocation toward energy stocks and away from airlines if you anticipate high gas prices Your allocation between stocks, bonds, and other assets remains the same, but the allocation between two sectors is altered.

al-The words diversifi cation and asset allocation are often used in this text

Diversi-fi cation is important because it reduces your risk exposure Asset allocation is tant because it has a major impact on the return your portfolio earns Whenever you make an investment decision, you need to consider its impact on the diversifi cation of your portfolio and the allocation of your assets Both are crucial components of port-folio management

impor-EFFICIENT AND COMPETITIVE MARKETS

Have you ever been fi shing? (If not, substitute playing golf or some similar activity.) Did you catch any fi sh? Which fi sh did you talk about? The answer to that question

is probably the “big one” or the “big one that got away.” What is more important, of course, is the size of the average fi sh (or average golf score) If you go fi shing several times, you will not catch a “big one” every time or even frequently The average size of the fi sh you catch becomes the norm And other individuals who fi sh in the same waters will have comparable results Unless they have special skills or knowledge, most indi-viduals’ catch should be similar to and approach the average size of fi sh that is caught

In many ways, the fi shing analogy applies to investing in stock Individuals tend to talk about the big return (“I bought X and it doubled within a week”) or the lost op-portunity (“I bought Plain and Fancy Doughnuts of America It rose 80 percent within

an hour and I did not sell”) But what matters is the return you earn after making many investments over an extended period of time Unless you have special skills or knowl-edge, that return should tend to be comparable to the return earned by other investors

in comparable investments

Why is this so? The answer lies in the reality that investors participate in effi cient and competitive fi nancial markets Economics teaches that markets with many partici-pants (i.e., buyers and sellers) who may enter and exit freely will be competitive That certainly describes fi nancial markets Investors may participate freely in the purchase and sale of stocks and bonds Virtually anyone, from a child to a grandmother, may own a fi nancial asset, even if it is just a savings account Many fi rms, including banks, insurance companies, and mutual funds, compete for the funds of investors The fi nan-

cial markets are among the most (and perhaps the most) competitive of all markets.

Financial markets tend to be very effi cient As is explained throughout this text, securities prices depend on future cash fl ows, such as interest or dividend payments If new information suggests that these fl ows will be altered, the market rapidly adjusts the asset’s price Thus, an effi cient fi nancial market implies that a security’s current price embodies all the known information concerning the potential return and risk associated with the particular asset If an asset, such as a stock, were undervalued and offered an excessive return, investors would seek to buy it, which would drive the

price up and reduce the return that subsequent investors would earn Conversely, if the asset were overvalued and offered an inferior return, investors would seek to sell

it, which would drive down its price and increase the return to subsequent investors The fact that there are suffi cient informed investors means that a security’s price will refl ect the investment community’s consensus regarding the asset’s true value and also that the expected return will be consistent with the amount of risk the investor must bear to earn the return

The concept of an effi cient fi nancial market has an important and sobering lary Effi cient markets imply that investors (or at least the vast majority of investors)

corol-cannot expect on average to beat the market consistently Of course, that does not

mean an individual will never select an asset that does exceedingly well Individuals can earn large returns on particular assets, as the stockholders of many fi rms know Certainly the investor who bought Gold Kist stock on Friday, August 18, 2006, for

$12.93 and sold it one trading day later on Monday, August 21, 2006, for $19.02 made a large return on that investment (After trading closed on August 18, it was an-nounced that Pilgrim’s Pride would buy Gold Kist for $20 per share.) The concept of effi cient markets implies that this investor will not consistently select those individual securities that earn abnormally large returns

If investors cannot expect to outperform the market consistently, they also should not consistently underperform the market (That is, you would not always be the in-

vestor who sold Gold Kist just prior to the large increase in its price.) Of course, some

securities may decline in price and infl ict large losses on their owners, but effi cient markets imply that the individual who constructs a well-diversifi ed portfolio will not always select the stocks and bonds of fi rms that fail If such individuals do exist, they will soon lose their resources and will no longer be able to participate in the fi nancial markets

Thus, effi cient fi nancial markets imply that investors should, over an extended period of time, earn neither excessively positive nor excessively negative returns In-stead, their returns should mirror the returns earned by the fi nancial markets as a whole and the risk assumed by the investor As is covered in Chapter 10, the Ibbot-son studies (which are considered the benchmark for aggregate returns) indicate that the historical return on investments in stock in the country’s largest fi rms has been approximately 10 percent annually Smaller, but riskier, companies have generated higher returns These historical returns are consistent with the risk/return trade-off, that higher returns require more risk In an effi cient market framework, it would be reasonable to assume that over an extended period of time the typical investor earns returns that are consistent with these historical returns

While the concept of effi cient fi nancial markets permeates investments, the tion remains: How effi cient? As will be covered in Chapter 9, anomalies in the effi cient market hypothesis may exist Many of the various investment techniques and meth-ods of analysis covered in later chapters are designed to help identify these anomalies and increase investment returns You, of course, will have to decide for yourself how effi cient you believe fi nancial markets are, because that belief should determine which

ques-of the many investment strategies to follow A stronger belief in effi ciency argues for

a more passive strategy If you think markets are ineffi cient or that there are pockets

of ineffi ciency that you can exploit, then you will want to follow a more aggressive, active strategy