Fundamentals of Investments Flashcards
best efforts underwriting
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 underwriting
the underwriter agrees to buy the entire issuance of the stock from the company
the risk that an issuance may not sell resides with the underwriter
prospectus document
outlines the risk, management team, business operations, fees, and expenses
red herring document
preliminary prospectus issued before the SEC approval and is used to determine investors’ interest in the security
10K document
an annual report of financial statements filed with the SEC
audited
10Q document
a quarterly report that is filed with the SEC
not audited
annual report document
contains a message from the Chairman of the Board on the progress in the past year and outlook for the coming year
sent directly to shareholders
liquidity
how quickly something can be turned into cash, with little to no price concession
marketability
exists when there is a ready-made market for something
market order
timing and speed of execution are more important than price
when is a market order 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
when is a limit order most appropriate?
for stocks that are extremely volatile and are not frequently traded
stop order
the price hits a certain level and turns to a market order
once the stop price is reached, the stock is sold at that price or possibly less because it has become a market order
what is the risk with a stop order?
the risk is that the investor may receive significantly less than anticipated if the market is moving too quickly
stop-loss limit order
the investor sets 2 prices:
1. the stop-loss price (once the price is reached, the order turns to a limit order)
- limit price (an investor will not sell below the second price)
what is the risk with a stop-loss limit order?
the risk is that if the market moves quickly, the order may not fill and the investor will be left with the stock at a significantly lower price
short-selling
selling first at a higher price, in the hopes of purchasing the stock back at a lower price
when is short-selling appropriate?
when the investor anticipates the price of an asset to decrease in value
initial margin
reflects the amount of equity an investor must contribute to enter a margin transaction
maintenance margin
the minimum amount of equity required before a margin call
margin position (definition)
the current equity position of the investor
margin position (formula)
margin position = equity / FMV
equity (formula)
equity = stock price - loan
margin call (formula)
margin call = loan / (1 - maintenance margin)
what happens when there is a margin call?
the investor must contribute equity to restore their equity position
Value Line
ranks stocks on a scale of 1 to 5 for timeliness and safety
what is the best and worst ranking for Value Line?
best = 1 (signal to buy) worst = 5 (signal to sell)
Morningstar
ranks mutual funds, stocks, and bonds using 1 to 5 starts
what is the best and worst ranking for Morningstar?
best = 5 stars worst = 1 star
ex-dividend date
the date the stock trades without the dividend
when is the ex-dividend date in relation to the date of record?
the ex-dividend date is one business day before the date of record
date of record
the date on which you must be a registered shareholder in order to receive the dividend
when is a cash dividend taxed?
upon receipt
when is a stock dividend taxed?
when the stock is sold
what is a stock split?
increases shares outstanding and reduces stock price
Securities Act of 1933
regulates the issuance of new securities (primary market)
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
Investment Company Act of 1940
authorized the SEC to regulate investment companies
Investment Advisors Act of 1940
required investment advisors to register with the SEC or the state
Securities Investors Protection Act of 1970
established the SIPC to protect investors from losses resulting from brokerage firm failures
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 trade on that information
Treasury Bills
- issued in varying maturities up to 52 weeks
- denominations in $100
Commercial Paper
- short-term loans between corporations
- maturities of 270 days or less
- does not have to register with SEC
- denominations of $100,000
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
what is an Investment Policy Statement?
establishes a client’s objectives and limitations on investment manager
used to measure investment manager’s performance
what are the objectives and constraints detailed on the Investment Policy Statement?
objectives:
- return requirements
- risk tolerance
constraints:
- time horizon
- liquidity
- taxes
- laws and regulations
- unique circumstances
Dow Jones Industrial Average
simple price-weighted average
does NOT incorporate market capitalization
S&P 500
value-weighted index
incorporates market capitalization of individual stocks
Russell 2000
value-weighted index of the smallest market cap stocks in the Russell 3000
Wilshire 5000
the broadest index that measures the performance of over 3000 stocks
value-weighted index
EAFE
value-weighted index that tracks stocks in Europe, Australia, Asia, and the Far East
what are the 4 basic premises of Traditional Finance?
- investors are rational
- markets are efficient
- the mean-variance portfolio theory governs
- returns are determined by risk
what does it mean to say that investors are rational?
investor decisions are logical, centered on a clearly defined goal, free from the unsteady influences of emotion or irrationality, and take into account all available information
what does it mean to say that markets are efficient?
at any given time, a stock’s share price in the market incorporates and reflects all relevant information about that stock
what is the mean-variance portfolio theory?
mean-variance investors choose portfolios by viewing and evaluating mean returns and variance for their entire portfolio
what are the 4 basic premises of Behavioral Finance?
- investors are normal
- markets are not efficient
- the behavioral portfolio theory governs
- risk alone does not determine returns
what does it mean to say that investors are normal?
normal investors have normal wants and desires, but may commit cognitive errors (through biases or otherwise)
normal investors may be misled by emotions
what is the behavioral portfolio theory?
investors segregate their money into various mental accounting layers
investors compartmentalize certain goals to be accomplished in different categories based on risk rather than viewing their entire portfolio as a whole
affect heuristic
deals with judging something, whether it is good or bad
anchoring
attaching one’s thoughts to a reference point even though there may be no logical relevance or is not pertinent to the issue in question
availability heuristic
when a decision maker relies upon knowledge that is readily available in his or her memory
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 decision
decision-makers in this view act as “satisficers”
confirmation bias
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 an existing opinion
disposition effect
aka regret avoidance
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’s fallacy
investors often have incorrect understanding of probabilities which can lead to faulty predictions
herding
people tend to follow the masses or the “herd”
hindsight bias
hindsight is 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
concerns an investor that listens mostly to his or herself
overconfident investors mostly rely on their skills and capabilities to do their own homework or make their own decisions
overreaction
a common emotion towards the receipt of news or information
prospect theory
people value gains and losses differently
recency
giving too much weight to recent observations or stimuli
similarity heuristic
used when a decision or judgement is made when an 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
AKA 1/n diversification
