Fundamental of Investments (L1) Flashcards
Forms of Underwriting
- Best Efforts
○ The Underwriter agrees to sell AS MUCH OF THE
OFFERING AS POSSIBLE
○ The risk of the issue NOT selling resides with the
firm because any shares not sold to the public are
returned to the company - Firm Commitment
○ The Underwriter to buy the ENTIRE ISSUANCE of
the stock from the company
○ The underwriter may buy the stock from the
company for $18 shares and sell to the public at $20
per share, THUS making the spread
○ The risk = Underwriter
Key Documents
- Prospectus
- Red Herring
- 10K
- 10Q
- Annual Report
Prospectus
- Outlines…
○ Risks
○ Management team
○ Business operations
○ Fees
○ Expenses - MUST BE issued by an investment company PRIOR to selling share to an investor
Red Herring
- PRELIMINARY PROSPECTUS
- Issued BEFORE the SEC approval and is used to determine investors’ interest in the security
10K
○ Annual report of financial statements filed with the SEC
○ AUDITED
10Q
○ Quarterly report that is filed with the SEC
○ NOT AUDITED
Annual Report
○ Contains certain messages from the Chairman of the Board on the progress in the past year and outlook for the coming year
○ The Annual Report is sent directly to shareholder
Liquidity vs Marketability
- Liquidity
○ How quickly something that can be turned in to
CASH (with little to no concession).
○ Generally short-term investment assets are
consider liquid
○ NOT consider Liquid
§ Stocks
§ Bonds
§ Stock mutual funds
§ Stock bond funds - Marketability
○ When there is a ready-made market for something
○ Real Estate is marketable, BUT NOT Liquid
Market Order
○ Timing and speed of execution are more important than price
○ Most appropriate for stocks that ARE NOT thinly traded
Limit Order
○ The price at which the trade is executed is MORE important than the timing
○ Most appropriate for stocks that are extremely volatile and are not frequently traded
Stop Order
- The price hits a certain level and turns into a market order
- Stop Order to Sell
○ Once the stop order price is reached, the stock is
old at that price or possibly less because it has
become a market order - PRIMARY RISK
○ The investor may receive significantly LESS than
anticipated if the market is moving too quickly
Stop-Limit or Stop-Loss Limit Order
- The investor set 2 prices:
○ 1st price ==> stop loss price, once the price is
reached the order turns into a limit order
○ 2nd price ==> limit price. An investor will not sell
below the second price - Risk is that the market moves quickly, the order may not fill and the investor will be left with the stock at a significantly lower price
- A Stop-Loss Limit Order
○ Appropriate for investors with a significant gain
built into the stock, but may not want to sell the
stock during a period of significant volatility based
on short-term news.
Short Selling
- Selling first at a higher price, in the hopes of purchasing the stock back at a lower price
- GOAL = Sell High and Buy Low
- Investor makes a profit when the assets prices decrease in value
- Short selling is the OPPOSITE of taking a long position, where the investor anticipates making a profit when the price of the assets increase in value
- Investor must have a margin account to protect against any price appreciation of the stock
- There is NO TIME LIMIT on how long an investor can maintain the short position
- Dividends paid by a corporation must be covered by the short seller
Initial Margin
- Reflects the amount of equity an investor must contribute to enter a margin transaction
- Can be more restrictive based on the volatility of a stock
- REGULATION T
○ Set the intitial margin at 50%
○ Established by the Federal Reserve (FED)
Maintenance Margin
○ The minimum amount of equity required before a MARGIN CALL
Margin Position
Represents the current equity position of the investor
At what price does an investor receive a margin call price?
Margin Call = Loan / ( 1 - Maintenance Margin)
Formula is used to determine the price that investor will receive a margin call
MEMORIZE FORMULA (NOT on CFP formula sheet)
How much equity must an investor contribute?
When a stock price FALLS BELOW the stock price at which an investor will receive a margin call, the investor will receive a margin call and must contribute equity to restore their equity position.
Research Reports
- Value Line
○ Ranks stock on a scale of 1-5 for timeliness and
safety
○ Ranking 1 ==> HIGHEST rating (signal to buy)
○ Ranking 5 ==> LOWEST rating (signal to sell) - Morningstar
○ Ranks MFs, stocks, and bonds using 1-5 stars
○ 1 star = LOWEST
○ 5 start = HIGHEST
Dividend Dates
- Dividends are declares by the Board of Directors and are typically paid QUARTERLY
- 2 important dates:
○ Ex-dividend date
○ Date of Record (RECORD DATE) - Ex-Dividend Date
○ Once business day BEFORE the Record Date
○ The date the stock trades WITHOUT the dividend
○ If you sell the stock on the Ex-Dividend date, then
you will receive the dividend
○ If you buy the stock on the Ex-Dividend date, the
you will NOT receive the dividend - Date of Record (Record Date)
○ The date on which you must be a registered
shareholder in order to receive the dividend
○ One business day AFTER the Ex-Dividend date
○ An investor must purchase the stock 2 business
days PRIOR to the date of record in order to receive
the dividend
○ Purchases made on ex-dividend date will NOT
receive the dividend (ex-date = trades without
dividend)
Dividends and Splits
- Cash Dividends
○ Taxed upon receipt
○ Qualified dividends = Capital Gain Treatment - Stock Dividends
○ NOT TAXABLE to the shareholder until the stock is
sold - Stock Splits
○ Increase shares outstanding and reduces stock
prices (basis remains constant)
§ 2-for-1 split for 100 shares at $50 per share
□ Shares = 200
□ Stock price = $25 per share§ 3-for-2 split for 100 shares at $60 per share □ Shares = 150 □ Stock Price = $40 per share
Security Regulations
- Securities act of 1933
○ Regulates the issuance of new securities (Primary
Market - IPO)
○ Requires new issues are accompanied with a
prospectus before being purchased - Securities Act of 1934
○ Regulates the Secondary Market and trading of
securities
○ Created the SEC to enforce compliance with
security regulations and laws - Investment Company Act of 1940
○ Authorized the SEC to regulate investment
companies
○ Three types of investment companies
§ Open
§ Closed
§ Unit Investment Trusts (UIT) - Investment Advisor Act of 1940
○ Required IA’s to register with the SEC or State - Securities Investors Protection Act of 1970
○ Established SIPC to protect investors for losses
resulting from brokerage firm failures
○ Does NOT protect investors from incompetence or
bad investment decisions
○ Protects account member firms open for clients,
regardless of the clients citizenship - Insider Trading and Securities Fraud Enforcement Act of 1988
○ Defines an insider as anyone with information that
is not available to the public
○ Insiders CANNOT on that information
Money Market Securities
- T-Bills
○ Issued in varying maturities up to 52 weeks
○ Denominations in $100 increments through
Treasury Direct up to $5M per auction.
○ Larger amounts available through a competitive
bid - Commercial Paper
○ Short-Term Loans between corporations
○ Maturities of 270 days or less and it does not have
to register with the SEC
○ Denominations of $100,000 and are sold at a
discount - Bankers’ Acceptance
○ Facilitates imports/exports
○ Maturities of 9 months or less
○ Can be held until maturity or traded - Eurodollars
○ Deposits in foreign banks that are denominated in
US dollars
Investment Policy Statement
- Establishes:
○ A clients objectives
○ Limitations on investment mangers - Used to measure investment managers performance
- The investment policy statement DOES NOT include investment selection
- Establishes “RR TTLLU”
○ Risk
○ Return
○ Taxes
○ Time horizon
○ Liquidity
○ Legal
○ Unique circumstances
Market Averages and Indices
- Does Jones Industrial Averages
○ A simple PRICE WEIGHTED average
○ DOES NOT incorporate market capitalization - S&P 500
○ VALUE WEIGHTED index
○ Incorporates market capitalization of individual
stocks into the average - Russell 2000
○ VALUE WEIGHTED index
○ Smallest market capitalization stock in the Russell
3000 - Wilshire 5000
○ The BROADEST index that measures performance
of over 3,000 stocks
○ VALUE WEIGHTED INDEX - EAFE
○ VALUE WEIGHTED index
○ Tracks stocks in Europe, Australia, Asia, and the Far
East
4 basic premises of traditional finances
- Investors are Rational
○ Investors decisions are logical, centered on a clearly defined goal and free from the unsteady influences of emotion or irrationality, and take into account all available information - Markets are Efficient
○ At any given time, a stocks share price in the market incorporates and reflects all relevant information about that stock - The Mean-Variance Portfolio Theory Governs
○ Investors choose portfolios by viewing and evaluating means returns and variance for their entire portfolios - Returns are determined by Risk
○ CAPM is the basic theory that links returns and risk for all assets by combining a risk-free asset with risk assets from an efficient market
Behavioral Finance ASSUMPTIONS
- Investors are “Normal”
○ Normal investors have normal wants and desires, but may commit cognitive errors
○ May be misled by emotions while they are trying to achieve their wants - Markets are NOT Efficient
○ There can be deviation in price from fundamental value so that there are opportunities to buy at a discount or sell at a premium - The Behavioral Portfolio Theory Governs
○ Investors segregate their money into various mental accounting layers
○ This mental process occurs when people “compartmentalize” certain goals to be accomplished in different categories based on risk rather viewing their entire portfolio as a whole. This may result in having very different risk preferences for the same value depending on the goal or situation - Risk Alone does not determine returns
○ The Behavioral Asset Pricing Model Determines the expected return of a stock using Beta, book to market ratios, market capitalization ratios, stock “momentum”, the investors likes or dislikes about the stock or company, social responsibility factors, status factors and more.
Affect Heuristic
Deals with judging someone, whether good or bad. Do they like or dislike some company based on non-financial issues
Anchoring
○ Attaching or anchoring one’s thoughts to a reference point even though there may be no logical relevance or is not pertinent to the issue in question.
○ Conservatism OR Belief perseverance
Availability Heuristics
○ When a decision maker relies upon knowledge that is readily available in his or her memory, the cognitive heuristic known as “availability” is invoked
○ This may cause investors to overweight recent events or patterns while paying little attention to longer term trends
Bounded Rationality
○ When individuals make decisions, their rationality is limited by the available information, the tractability of the decision problem, the cognitive limitations of their minds, and the time available to make the decisions
○ Decision makers in this view act as “satisficers”, seeking a satisfactory solution rather than an optimal one
○ Once consequence of this concept is that having additional information does not lead to an improvement in decision making due to the inability of investors to consider significant amounts of information
Confirmation Bias
○ A commonly used and popular phrase is that “you do not get a second chance at a first impression”
○ People tend to filter information and focus on information supporting their opinions
Cognitive dissonance
The tendency to misinterpret information that is contrary to an existing opinion OR only pay attention to information that supports existing opinion
Disposition effect
○ Regret avoidance OR “faulty framing”
○ Normal investors do not mark their stock to market prices.
○ Investors create mental accounts when they purchase stocks and continue to mark their value to purchase prices even after market prices have changed
Familiarity Bias
Investors tend to overestimate/underestimate the risk of investments with which they are unfamiliar/familiar
Gambler fallacy
Investors often have incorrect understanding of probabilities which can lead to faulty predictions
Herding
○ People tend to follow the herd or masses
○ Herd Mentality Leads to…
§ Buying HIGH
§ Selling LOW
Hindsight bias
Looking back after the fact is known and assuming they can predict the future as readily as they can explain the past
Illusion of control bias
The tendency for people to overestimate their ability to control events
Overconfidence Bias
○ Usually concerns an investor that listens mostly to himself/herself
○ Investors mostly rely on their skills and capabilities to do their own homework OR make their own decisions.
○ Causes many investors to overstate their risk tolerance
Overreaction
A common emotion towards the receipt of new or information
Prospect Theory
Provides that people value gains or losses differently and will base their decisions on perceived gains rather than perceived losses.
Recency
Giving too much weight to recent observations or stimuli
Simplicity heuristics
Used when a decision or judgement is made when apparently similar situation occurs even though the situations may have very different outcomes
Naive Diversification
○ The process of investing in every option available to the investor
Representativeness
○ Thinking that a good company is a good investment WITHOUT regard to an analysis of the investment
Familiarity
Causes investment in companies that are familiar, such as an ER.
Loss Aversion
○ Suggests investors prefer avoiding losses more than experiencing gains
○ Unwillingness to sell a losing investment, in hopes that it will turn around
Managing Biases
- It is natural and common that investors have biases
- Goal of the planner will be to assist the client with not making irrational or emotional decisions that do not align with the state’s goals and objectives
- Techniques to assist with removing bias
○ Changing the environment in which the decision is
being made
○ Educating the client on the topic
○ Having the client play devil’s advocate for the
opposing viewpoint
○ Reviewing the clients state goals and objectives
Socialization
The process of acquiring values, beliefs, and behaviors that are acceptable and or expected by society
Multicultural Psychology
“an extension of general psychology that recognizes that multiple aspects of identity influences a person’s worldview, including race, ethnicity, language, sexual orientation, gender, age, disability, class status, education, religious or spiritual orientation, and other cultural dimensions, and that both universal and culture-specific phenomena should be taken into consideration when psychologist are helping clients, training students, advocating for social change and justice, and conducting research”
Social Consciousness
An awareness of and sense of responsibility for problems or injustices that exist within society.
