Fundamentals of Investing, Global Edition (PDF) - Chapter Introduction

1 The Investment Environment MyLab Finance Chapter Introduction Video...

1 The Investment Environment MyLab Finance Chapter Introduction Video LEARNING GOALS After studying this chapter, you should be able to: Understand the meaning of the term investment and list the attributes that distinguish one investment from another. Describe the investment process and types of investors. Discuss the principal types of investments. Describe the purpose and content of an investment policy statement, review fundamental tax considerations, and discuss investing over the life cycle. Describe the most common types of short-term investments. Describe some of the main careers available to people with financial expertise and the role that investments play in each. Y ou have worked hard for your money. Now it is time to make your money work for you. Welcome to the world of investments. There are literally thousands of investments, from all around the world, from which to choose. How much should you invest, when should Copyright © 2019. Pearson Education, Limited. All rights reserved. you invest, and which investments are right for you? The answers depend upon the knowledge and financial circumstances of each investor. Financial news is plentiful, and finding financial information has become easier than ever. Traditional media outlets, including TV networks such as CNBC, Bloomberg Television, and Fox Business Network and print-based powerhouses such as The Wall Street Journal and The Financial Times, provide financial advice for individual investors. However, more people obtain in- vestment information from the Internet than from all other sources combined. The Internet makes enormous amounts of information readily available, enables investors to trade securities with the click of a mouse, and provides free and low-cost access to tools that were once restricted to pro- fessional investors. All of this helps create a more level playing field—yet at the same time, such easy access can increase the risks for inexperienced investors. Whether you are an experienced investor or a novice, the same investment fundamentals apply. Perhaps the most fundamental principle in investing, and one that you would be wise to keep in mind whenever you invest, is this—there is a tradeoff between an investment’s risk and its return. Most people would like their investments to be as profitable as possible, but there is an almost unavoidable tendency for investments with the greatest profit potential to be associated with the highest risk. You will see examples of the link between risk and return throughout this text. First, we address the question, “What is an investment?” Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, 35 http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-12 12:23:31.  36 PART ONE I PREPARING TO INVEST Investments and the Investment Process You are probably already an investor. If you have money in a savings account, you have at least one investment to your name. An investment is any asset into which you place funds with the expectation that it will generate positive income and/or increase NOTE The Learning Goals shown at the its value. A collection of different investments is called a portfolio. beginning of the chapter The rewards, or returns, from investing come in two basic forms: income and in- are keyed to text creased value. Money invested in a savings account provides income in the form of peri- discussions using these icons. odic interest payments. A share of common stock may also provide income (in the form of dividends), but investors often buy stock because they expect its price to rise. That is, common stock offers both income and the chance of an increased value. In the United States since 1900, the average annual return on a savings account has been a little more than 4%. The average annual return on common stock has been about 11.5%. Of course, during major market downturns (such as the one that occurred in 2008), the returns on nearly all investments fall well below these long-term historical averages. Is cash placed in a non-interest-bearing checking account an investment? No, be- cause it fails both tests of the definition: It does not provide added income, and its value does not increase. In fact, over time inflation erodes the purchasing power of money left in a non-interest-bearing checking account. Attributes of Investments When you invest, the organization in which you invest—whether it is a company or a government entity—offers you the prospect of a future benefit in exchange for the use of your funds. You are giving up the use of your money, or the opportunity to use that money to consume goods and services today, in exchange for the prospect of having more money, and thus the ability to consume goods and services, in the future. Organizations compete for the use of your funds, and just as retailers compete for cus- NOTE Investor Facts tomers’ dollars by offering a wide variety of products with different characteristics, or- offer interesting or entertaining tidbits of ganizations attempting to raise funds from investors offer a wide variety of investments information. with different attributes. As a result, investments of every type are available, from virtually zero-risk savings accounts at banks, which in recent years offered returns hovering barely above 0%, to shares of common stock in high-risk compa- Copyright © 2019. Pearson Education, Limited. All rights reserved. INVESTOR FACTS nies that might skyrocket or plummet in a short time. The investments you Art as an Asset Is art a good choose will depend on your resources, your goals, and your willingness to investment? Paintings and other take risk. We can describe a number of attributes that distinguish one type artworks trade infrequently (i.e., of investment from another. they are illiquid), so measuring the investment performance of art is Securities or Property Securities are investments issued by firms, govern- difficult. Using sophisticated sta- tistical methods, one study pegged ments, or other organizations that represent a financial claim on the issuer’s the average annual return on art resources. The most common securities are stocks and bonds, but more ex- (from 1961 to 2013) at just over otic types such as stock options are available as well. One benefit of invest- 6%. That figure is higher than the ing in securities is that they often have a high degree of liquidity, meaning returns earned on investments in that you can sell securities and convert them into cash quickly without in- real estate and U.S. government securities but below returns de- curring substantial transaction costs and without having an adverse impact livered by commodities, corporate on the security’s price. Stocks issued by large companies, for example, tend bonds, and common stocks. to be highly liquid, and investors trade billions of shares of stock each day (Source: Based on “Does It Pay to in the markets all over the world. The focus of this text is primarily on the Invest In Art? A Selection-Corrected most basic types of securities. Returns Perspective,” Review of Financial Studies, 2016.) Property, on the other hand, consists of investments in real property or tangible personal property. Real property refers to land, buildings, and Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-12 12:23:31.  CHAPTER 1 I THE INVESTmENT ENVIRONmENT 37 things permanently affixed to the land. Tangible personal property includes INVESTOR FACTS items such as gold, artwork, antiques, and other collectibles. In most cases, Smart People Own Stocks The property is not as easy to buy or sell as are securities, so we would say that stock market participation rate property tends to be a relatively illiquid investment. Investors who want to refers to the percentage of households that invest in stocks sell a building or a painting may have to hire (and compensate) a real estate directly or indirectly. A study of agent or an art dealer to locate a buyer, and it may take weeks or months to investors from Sweden found sell the property. that an extra year of schooling increased the stock market par- Direct or Indirect A direct investment is one in which an investor directly ticipation rate by two percentage acquires a claim on a security or property. If you buy shares of common points and increased the share of wealth that individuals invested stock in a company such as Apple, then you have made a direct investment, in stocks by 10%. Another study and you are a part owner of that firm. An indirect investment is an invest- looked at investors from Finland ment in a collection of securities or properties managed by a professional and found a remarkable connec- investor. For example, when you send your money to a mutual fund com- tion between IQ and stock market pany such as Vanguard or Fidelity, you are making an indirect investment participation—people with higher IQ scores were much more likely in the assets held by these mutual funds. to invest in stocks than were Direct ownership of common stock has been on the decline in the people with lower IQ scores. more United States for many years. For example, in 1945 households owned remarkable still, the IQ measure (directly) more than 90% of the common stocks listed in the United States. used in this study was the score Over time that percentage dropped to its current level of about 30.5% (by on a test given to Finnish males when they were 19 or 20 years old comparison, 64% of U.S. households own a home). The same trend has as part of their induction to military occurred in most of the world’s larger economies. In the United Kingdom, service. IQ scores measured at for example, households’ direct ownership of shares fell from roughly 66% that early age were a very strong to 14% in the past half century. Today, households directly hold less than predictor of whether these men one-quarter of outstanding shares in most of the world’s major stock mar- would invest in stocks much later in life. kets, as Figure 1.1 shows. (Sources: Based on “Learning to Take Just as direct stock ownership by households has been falling, indirect Risks? The Effect of Education on Risk ownership has been rising. The percentage of U.S. households that owned Taking in Financial markets,” Review mutual funds (one means of obtaining indirect ownership of stocks and of Finance, 2018; “IQ and Stock market Participation,” Journal of Finance, other investments) rose from about 5% in 1980 to almost 55% in 2017. 2011.) Individuals have indirect ownership in stocks through many other types of financial institutions besides mutual funds. In 1945 institutional investors such as pension funds, hedge funds, and mutual funds combined held just Copyright © 2019. Pearson Education, Limited. All rights reserved. less than 2% of the outstanding stock in the United States, but today their direct own- ership is approaching 70%. Tax policy helps to explain the decline in direct stock ownership by individuals and the related rise in direct ownership by institutions such as mutual funds and pension funds. Starting in 1978, section 401(k) of the Internal Revenue Code allowed employ- ees to avoid paying tax on earnings that they elect to receive as deferred compensation, such as in a retirement savings plan. Since then, most large companies have adopted so-called 401(k) plans, which allow employees to avoid paying current taxes on the income that they contribute to a 401(k) plan. Employees are taxed on this income when they withdraw it during their retirement years. Typically, mutual fund companies manage 401(k) plans, so stocks held in these plans represent indirect ownership for the workers and direct ownership for the mutual fund companies. An important element of this trend is that individuals who trade stocks directly often deal with professional investors who sell the shares those individuals want to buy or buy what individuals want to sell. For instance, in 2018 Fidelity, one of the larg- est investment management companies in the world, had $2.5 trillion in assets in its various mutual funds, trusts, and other accounts, and the company employed approxi- mately 40,000 people, many of whom had advanced investments training and access to Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-12 12:23:31.  38 PART ONE I PREPARING TO INVEST FIGURE 1.1 United States 30.5 Direct Stock Ownership by Households Canada 28.3 The figure shows the Australia 24 percentage of common stocks in each country Japan 19.1 that is owned directly by households. In most Germany 14.5 countries, households own less than one-quarter of Sweden 14.3 the value of listed common stocks in the country. United Kingdom 14.1 (Source: Data from Finland 8.1 “Government Policy and Ownership of Equity France 6.1 Securities,” Journal of Financial Economics, 0 5 10 15 20 25 30 35 2014, Vol. 111, Issue 1, Percentage of Common Stocks Held by Households pp. 70–85.) a tremendous amount of information about the companies in which they invest. Given the preponderance of institutional investors in the market today, individuals are wise to consider the advantages possessed by the people with whom they are trading. Debt, Equity, or Derivative Securities Most investments fall into one of three broad categories—debt, equity, or derivatives. Debt is simply a loan that obligates the bor- rower to make periodic interest payments and to repay the full amount of the loan by some future date. When companies or governments need to borrow money, they issue securities called bonds. When you buy a bond, you lend money to the issuer. The issuer agrees to pay you interest and to repay the original loan at a specified time. Equity represents ongoing ownership in a business or property. An equity invest- Copyright © 2019. Pearson Education, Limited. All rights reserved. ment may be held as a security or by title to a specific property. The most common type of equity security is common stock. Derivative securities derive their value from an underlying security or asset. Stock options are an example. A stock option is an investment that grants the right to pur- chase (or sell) a share of stock at a fixed price for a limited time. The option’s value depends on the market price of the underlying stock. Low- or High-Risk Investments Investments also differ on the basis of risk. Risk re- flects the uncertainty surrounding the return that a particular investment will generate. To oversimplify things slightly, the more uncertain the return associated with an invest- ment, the greater its risk. One of the most important strategies that investors use to manage risk is diversification, which simply means holding different types of assets in an investment portfolio. As you invest over your lifetime, you will be confronted with a continuum of in- vestments that range from low risk to high risk. For example, stocks are generally considered riskier than bonds because stock returns vary over a much wider range and are harder to predict than are bond returns. However, it is not difficult to find high-risk bonds that are riskier than the stock of a financially sound firm. Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-12 12:23:31.  CHAPTER 1 I THE INVESTmENT ENVIRONmENT 39 In general, investors face a tradeoff between risk and return—to obtain higher returns, investors usually have to accept greater risks. Low-risk investments provide a relatively predictable, but also relatively low, return. High-risk investments provide much higher returns on average, but they also have the potential for much larger losses. Short- or Long-Term Investments The life of an investment may be either short or long. Short-term investments typically mature within one year. Long-term investments are those with longer maturities or, like common stock, with no maturity at all. Domestic or Foreign As recently as 30 years ago, U.S. citizens invested almost ex- clusively in purely domestic investments: the debt, equity, and derivative securities of U.S.-based companies and governments. The same could be said of investors in many NOTE Discussions of other countries. In the past, most people invested the vast majority of their money in international investing are highlighted by this icon. securities issued by entities located in their home countries. Today investors routinely also look for foreign investments (both direct and indirect) that might offer more at- tractive returns than purely domestic investments. Even when the returns offered by foreign investments are not higher than those found in domestic securities, investors may still choose to make foreign investments because they help them build more di- versified portfolios, which in turn helps limit exposure to risk. Information on foreign companies is readily available, and it is relatively easy to make foreign investments. The Structure of the Investment Process The investment process brings together suppliers who have extra funds and demanders who need funds. Households, governments, and businesses are the key participants in the investment process, and each of these participants may act as a supplier or a demander of funds at a particular time. However, there are some general tendencies. Households who spend less than their income have savings, and they want to invest those surplus funds to earn a return. Households, then, are generally net suppliers of funds. Governments, on the other hand, often spend more than their tax revenues, so they issue bonds and other debt securities to raise additional funds. Governments are typically net demanders of funds. Businesses are also net demanders of funds most of the time. They issue debt or equity securities to finance new investments and other activities. Copyright © 2019. Pearson Education, Limited. All rights reserved. Suppliers and demanders of funds usually come together by means of a finan- cial institution or a financial market. Financial institutions are organizations, such as banks, mutual funds, and insurance companies, that pool the resources of households and other savers and use those funds to make loans and to invest in securities. Financial markets are markets in which suppliers and demanders of funds trade financial assets, typically with the assistance of intermediaries such as securities brokers and dealers. All types of investments, including stocks, bonds, commodities, and foreign currencies, trade in financial markets. The dominant financial market in the United States is the securities market. It includes stock markets, bond markets, and options markets. Similar markets exist in most major economies throughout the world. The prices of securities traded in these markets are determined by the interactions of buyers and sellers, just as other prices are established in other kinds of markets. For example, if the number of Facebook shares that investors want to buy is greater than the number that investors want to sell, the price of Facebook stock will rise. As new information about the company becomes available, changes in supply (investors who want to sell) and demand (investors who want to buy) may result in a new market price. Financial markets streamline the pro- cess of bringing together buyers and sellers, so investors can transact with each other Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-12 12:23:31.  40 PART ONE I PREPARING TO INVEST quickly and inexpensively. Financial markets provide another valuable function by es- tablishing market prices for securities that are easy for market participants to monitor. For example, a firm that launches a new product may get an early indication of how that product will be received in the market by seeing whether investors drive the firm’s stock price up or down as they learn about the new product. Figure 1.2 is a diagram of the investment process. Note that the suppliers of funds may transfer their resources to the demanders through financial institutions, through financial markets, or in direct transactions. As the broken lines show, financial institu- tions can participate in financial markets as either suppliers or demanders of funds. For the economy to grow and prosper, funds must flow to those with attractive investment opportunities. If individuals began suddenly hoarding their excess funds rather than put- ting them to work in financial institutions and markets, then organizations in need of funds would have difficulty obtaining them. As a result, government spending, business expansion, and consumer purchases would decline, and economic activity would slow. When households have surplus funds to invest, they must decide whether to make the investment decisions themselves or to delegate some or all of that responsibility to professionals. This leads to an important distinction between two types of investors in the financial markets. Individual investors manage their own funds to achieve their fi- nancial goals. Individuals who lack the time or expertise to make investment decisions often employ institutional investors—investment professionals who earn their living by managing other people’s money. These professionals trade large volumes of securities for individuals, as well as for businesses and governments. Institutional investors in- clude banks, life insurance companies, mutual funds, pension funds, and hedge funds. Both individual and institutional investors apply similar fundamental principles when deciding how to invest money. However, institutional investors generally con- trol larger sums of money and have more sophisticated analytical skills than do most individual investors. The information presented in this text is aimed primarily at you— the individual investor. Mastering this material represents only the first step that you need to take to develop the expertise you need if you want to become an institutional investor. Copyright © 2019. Pearson Education, Limited. All rights reserved. FIGURE 1.2 Financial Institutions The Investment Process Financial institutions Banks participate in the financial Savings and Loans markets as well as transfer Savings Banks funds between suppliers Credit Unions Insurance Companies and demanders. Although Pension Funds the arrows go only from suppliers to demanders, for some transactions Suppliers Direct transactions Demanders (e.g., the sale of a bond of of Funds Funds or a college loan), the principal amount borrowed by the demander from the Financial Markets supplier (the lender) is Money (short term) eventually returned. Capital (long term) Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-12 12:23:31.  CHAPTER 1 I THE INVESTmENT ENVIRONmENT 41 CONCEPTS 1.1 Define the term investment, and explain why individuals invest. IN REVIEW 1.2 Differentiate among the following types of investments, and cite an example of each: Answers available at (a) securities and property investments; (b) direct and indirect investments; (c) debt, www.pearson.com/mylab/ equity, and derivative securities; and (d) short-term and long-term investments. finance 1.3 What is the relation between an investment’s risk and its return? NOTE The Concepts in Review questions at the end 1.4 Define the term risk, and explain how risk is used to differentiate among investments. of each text section 1.5 What are foreign investments, and what role do they play for the individual investor? encourage you, before you move on, to test your 1.6 Describe the structure of the overall investment process. Explain the role played by understanding of the financial institutions and financial markets. material you’ve just read. 1.7 Classify the roles of (a) government, (b) business, and (c) individuals as net suppliers or net demanders of funds. 1.8 Differentiate between individual investors and institutional investors. Types of Investments A wide variety of investments is available to individual investors. As you have seen, investments differ in terms of risk, maturity, and many other characteristics. We devote the bulk of this text to describing the characteristics of different investments and the strategies that you may use when you buy and sell these investments. Table 1.1 summa- rizes some basic information about the major types of investments that we will study. Short-Term Investments Short-term investments have a life of one year or less and usually (but not always) carry little or no risk. People buy these investments to put idle funds to use before transferring the money into a long-term investment. Short-term investments are also appealing to conservative investors who are reluctant to put their funds in riskier, long- term assets such as stocks or bonds. Copyright © 2019. Pearson Education, Limited. All rights reserved. Short-term investments provide liquidity because investors can convert them into cash quickly with little or no loss in value. Liquidity is important to investors because it is impossible to know when an emergency or other unplanned event will make it necessary to obtain cash by selling an investment. At such a time, selling an investment quickly is important. Of course, an investor willing to sell at a bargain price can convert almost any asset to cash quickly, but an investment that is liquid doesn’t require such a concession. Liquid investments give investors peace of mind that they can to get their hands on cash quickly if they need it without having to sell their investments at fire-sale prices. Common Stock Common stock is an equity investment that represents ownership in a corporation. Each share of common stock represents a fractional ownership interest in the firm. For example, in early 2018, Amazon had just over 484 million shares of stock outstanding. If you bought 100 shares of Amazon, you would be a part owner of that company, though your ownership stake would be just 0.000021%! Owners of common stock usually have the right to vote at shareholders’ meetings, but for most individual inves- tors, the voting rights are less important than the return they hope to earn. Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-12 12:23:31.  42 PART ONE I PREPARING TO INVEST TABLE 1.1 MAJOR TYPES OF INVESTMENTS Where Covered Type Description Examples in This Book ¯˚˘˚˙ Short-term Savings instruments with lives Deposit accounts, U.S. Treasury Ch. 1 investments of 1 year or less. Used to bills (T-bills), Certificates of de- warehouse idle funds and to posit (CDs), Commercial paper, provide liquidity. Money market mutual funds Common Equity investments that represent Chs. 6–9 stock ownership in a corporation. Fixed-income Investments that make fixed cash Bonds, Convertible securities Chs. 10, 11 securities payments at regular intervals. Preferred stock Web Ch. 16 Mutual funds Companies that pool money Large-cap funds, Growth funds Ch. 12 from many investors and invest funds in a diversified portfolio of securities. Exchange- Investment funds, typically index Stock index funds, Bond Ch. 12 traded funds, that are exchange listed index funds funds and, therefore, exchange traded. Hedge funds Alternative investments, usu- Long and short equities, Funds Ch. 12 ally in pools of underlying of funds securities, available only to sophisticated investors, such as institutions and individuals with significant assets. Derivative Securities that are neither debt Options Ch. 14 securities nor equity but are structured Futures Ch. 15 to exhibit the characteristics of the underlying assets from which they derive their value. Other Various other investments that Tax-advantaged investments Web Ch. 17 popular are widely used by investors. Real estate Web Ch. 18 investments Tangibles Web Ch. 18 The return on common stock comes from two sources: dividends and capital gains. Copyright © 2019. Pearson Education, Limited. All rights reserved. Dividends are payments the corporation makes to its shareholders. Companies are not required to pay dividends, and most firms that are small or are growing very rapidly do not pay dividends. As firms grow and accumulate cash, they often start paying divi- dends, just as Hawaiian Airlines did in 2017. Companies that pay dividends usually pay them quarterly. Capital gains occur when the stock price rises above an investor’s initial purchase price. Capital gains may be realized or unrealized. If you sell a stock for more than you paid for it, you have realized a capital gain. If you continue to hold the stock rather than sell it, you have an unrealized capital gain. Example Suppose you purchased a single share of McDonald’s common stock for $119.62 McDonald’s on January 3, 2017, the first day that the stock market was open for trading that Common year. During 2017 you received $3.83 in cash dividends. At the end of the year, you Stock Return sold the stock for $172.12. You earned $3.83 in dividends and you realized a $52.50 capital gain ($172.12 sale price − $119.62 purchase price) for a total dollar return of MyLab Finance $56.33. On a percentage basis, the return on McDonald’s shares in 2017 is calculated Solution Video as $56.33 , $119.62 = 0.471 or 47.1%. If you continued to hold the stock rather than sell it, you would have earned the same return, but your capital gain would have been unrealized. Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-12 12:23:31.  CHAPTER 1 I THE INVESTmENT ENVIRONmENT 43 As mentioned earlier, since 1900 the average annual rate of return on common stocks has been about 11.5%, so 2017 was a good year for McDonald’s. As a fast food producer, McDonald’s stock generally performs better when the economy is growing (as it was in 2017) and consumers are more willing to pay for food at restaurants rather than eating at home. Fixed-Income Securities Fixed-income securities are investments that offer a periodic cash payment that may be fixed in dollar terms or may vary according to a predetermined formula (for example, the formula might dictate that cash payments rise if a general rise in market interest rates occurs). Some offer contractually guaranteed returns, meaning that the issuer of the security (i.e., the borrower) must fulfill a promise to make payments to investors or risk being sued. Other fixed-income securities come with the expectation of regular payments even if a contractual obligation is absent. Because of their relatively pre- dictable cash payments, fixed-income securities tend to be popular during periods of economic uncertainty when investors are reluctant to invest in riskier securities such as common stocks. Fixed-income securities are also attractive during periods of high interest rates when investors seek to “lock in” high returns, especially if interest rates are above the inflation rate. The most common fixed-income securities are bonds, con- vertible securities, and preferred stock. Bonds Bonds are long-term debt instruments issued by corporations and govern- ments. A bondholder has a contractual right to receive periodic interest payments plus return of the bond’s principal, face value, or par value (the original loan amount) at maturity. If you purchased a bond with a $1,000 par value paying 6% interest in semi- annual installments, you would receive an interest payment equal to +1,000 * 6, * ½ year = +30 every six months. At maturity you would also receive the bond’s $1,000 face value. Bonds vary a great deal in terms of liquidity, so they may or may not be easy to sell prior to maturity. Since 1900 the average annual rate of return on long-term government bonds has been about 5.3%. Corporate bonds are riskier because they are not backed by the full Copyright © 2019. Pearson Education, Limited. All rights reserved. faith and credit of the U.S. government and, therefore, tend to offer slightly higher re- turns than government bonds provide. Convertible Securities A convertible security is a special type of fixed-income in- vestment. It has a feature permitting the investor to convert it into a specified num- ber of shares of common stock. Convertibles provide the fixed-income benefit of a bond (interest) while offering the price-appreciation (capital gain) potential of common stock. Preferred Stock Like common stock, preferred stock represents an ownership interest in a corporation and has no maturity date. Unlike common stock, preferred stock has a fixed dividend payment (in either dollar or percentage terms), and preferred stockhold- ers often have no voting rights. Firms are generally required to pay dividends on pre- ferred shares before they pay dividends on their common shares. Furthermore, if a firm is having financial difficulties and decides to stop paying preferred dividends, it may have to make up all of the dividend payments that it skipped before paying dividends on common shares. Investors typically purchase preferred stocks for the dividends they pay, but preferred shares may also provide capital gains. Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-12 12:23:31.  44 PART ONE I PREPARING TO INVEST Mutual Funds A mutual fund is a portfolio of stocks, bonds, or other assets purchased with a pool of funds contributed by many different investors and managed by an investment com- pany on behalf of its clients. In addition to mutual funds, investment compa- INVESTOR FACTS nies operate similar investment vehicles such exchange-traded funds (ETFs). The Feeling’s Mutual! In 2017, the Investors in a mutual fund or an ETF own an interest in the fund’s collec- 16,818 funds managed by invest- tion of securities. Most individual investors who own stocks do so indirectly ment companies in the United by purchasing mutual funds that hold stocks. When they send money to a States accounted for investment assets of $22 trillion. These mutual mutual fund, investors buy shares in the fund (as opposed to shares in the funds and ETFs held 31% of all U.S. companies in which the fund invests), and the price of the mutual fund’s stocks and managed 24% of all shares reflects the value of the assets that the fund holds. Mutual funds allow household financial assets. investors to construct well-diversified portfolios without having to invest a (Source: 2018 Investment Company large sum of money. After all, it’s cheaper to buy shares in a fund that holds Fact Book, downloaded from http:// 500 stocks than it is to buy shares in 500 companies on your own. In the www.icifactbook.org/, accessed may 9, 2018) last three decades, the mutual fund industry has experienced tremendous growth. The number of equity mutual funds (i.e., funds that invest mainly or exclusively in common stock) has more than quadrupled since 1980. Most mutual fund managers follow one of two broad approaches when selecting specific securities for their funds. In an actively managed fund, managers try to iden- tify and purchase securities that are undervalued and are therefore likely to perform particularly well in the future. Or managers try to identify overvalued securities that may perform poorly and avoid those investments. The goal of an actively managed fund is to earn a higher return than some sort of benchmark. For a mutual fund that invests in stocks, a common goal is to earn a return that is higher than the return on a market index like the Standard & Poor’s 500 Stock Index (S&P 500). In a passively managed fund, managers make no attempt to identify under- or overvalued securities. Instead, they buy a diversified portfolio of stocks and try to mimic or match the return on a market index. Because these funds provide returns that are close to the returns on a market index, they are called index funds. For more than a decade, index funds have been growing, meaning that they have been attracting new dollars from investors, while actively managed funds have been shrinking as investors withdraw dollars from those funds to invest in passively managed funds. In return for the services they provide, mutual funds (or rather, the investment Copyright © 2019. Pearson Education, Limited. All rights reserved. companies that run the mutual funds) charge investors fees, and some of those fees are rolled together in a figure known as the expense ratio. The expense ratio is a fee charged to investors based on a percentage of the assets invested in a fund. It accrues daily and represents one of the primary costs that investors pay when they purchase mutual fund shares. For example, if an individual has $10,000 invested in a mutual fund with an expense ratio of 1%, then the fund will charge $100 per year to manage the individual’s money. Expense ratios are generally higher for funds that invest in riskier securities. For example, in 2017 the average expense ratio among mutual funds investing in stocks was 0.59%, meaning that investors would pay expenses equal to $59 per $10,000 invested. For funds that invest in bonds, the average expense ratio was 0.48%. Money market mutual funds (also called money funds) are mutual funds that invest solely in short-term investments. The average expense ratio for money market mutual funds in 2017 was just 0.25%. Expense ratios also tend to be higher for actively managed funds. That shouldn’t be surprising because actively managed funds are more expensive to operate. In 2017, the average expense ratio for equity index funds was 0.09%, just one-ninth of the aver- age expense ratio for actively managed equity funds (0.78%). For many years, expense Smart, Scott, and Chad Zutter. Fundamentals of Investing, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/suss/detail.action?docID=5843857. Created from suss on 2024-10-12 12:23:31.  CHAPTER 1 I THE INVESTmENT ENVIRONmENT 45 ratios have been declining, a trend that is partly driven by the growing popularity of passively managed funds. The average expense ratio for equity mutual funds fell 27 basis points (or just over one quarter of one percent) in the last decade, from 0.86% in 2007 to 0.59% in 2017. Falling expense ratios is good news for mutual fund investors. Even so, there is considerable variation in expense ratios from one fund to another, so investors need to pay close attention to expenses before they choose a fund. In addition to the expense ratio, some funds charge a fee called a load. A load may be charged up front when the investor initially buys shares in the fund, in which case it is called a sales load. Alternatively, when investors sell their shares the fund may charge a fee known as a redemption fee or back-end load. Typically, redemption fees are reduced or waived entirely if investors keep their money in the fund for a long time. Exchange-Traded Funds Like mutual funds, exchange-traded funds (ETFs) hold portfolios of securities, and investors buy shares in the ETF. ETFs are very similar to mutual funds. They allow investors to form well-diversified portfolios with low initial investments, and the fees charged by ETFs are generally quite low. However, there are some important differ- ences between ETFs and mutual funds. The main distinction is that ETFs trade on exchanges, so investors can buy and sell an ETF at its current market price any time during regular trading hours. Mutual fund shares are not traded on exchanges, and when an investor buys (or sells) shares in a fund from an investment company, the transaction occurs at the end of the day using the fund’s closing price, which is deter- mined by adding up the values of the securities the fund holds at the end of the day and dividing by the number of shares in the fund. If stock prices are changing rapidly during the day, ETF investors may be able to take advantage of this by purchasing or selling their shares before prices hit their peak (or bottom). Investors in mutual funds have to wait until the day’s end to learn the price at which they can trade fund shares. Another important difference has to do with what happens to the money when in- vestors buy or sell shares. When investors buy shares in a mutual fund, the fund has more money than it had before, so the fund’s managers will likely use those funds to buy more securities. Similarly, if investors sell shares in the fund, the fund’s managers may have to sell securities to raise the cash needed to redeem shares. If many investors want to sell Copyright © 2019. Pearson Education, Limited. All rights reserved. their shares simultaneously, that may trigger a fire sale—the fund manager has to accept lower prices to quickly convert the fund’s assets into cash. In contrast, ETF shares repre- sent a fixed number of claims on a fixed portfolio. When investors buy ETF shares, they