Investment Basics: Stocks, Bonds, Risks, and Returns

What is an investment?

An investment is any asset into which funds can be placed with the expectation that it will generate a positive return.

What are the two forms of returns from an investment?

Income (interest, dividends) and Increased value (appreciation in value over purchase price).

What does equity represent in investing?

Equity represents ownership; the investor is an owner.

What does debt represent in investing?

Debt represents a loan; the investor is a lender.

What is the main advantage of equity investments?

The potential for higher returns from capital appreciation.

What is the main advantage of debt investments?

They supply predictable income from regularly scheduled interest payments.

What is the relationship between risk and returns in investments?

Higher returns are associated with higher risk; safe investments have lower returns.

What is the formula for calculating the Rate of Return?

Rate of Return = (Increase or decrease in value + annual income) / original investment.

What is inflation risk?

The risk that the financial return on the investment will not keep pace with inflation.

What is interest rate risk?

The risk that the value of fixed rate return investments will decrease when interest rates rise.

What is market risk?

The risk associated with overall risks in the market and the economy, which can be systematic or unsystematic.

What is asset allocation?

The process of spreading your assets among several different types of investments to lessen risk.

What factors should you consider for your asset allocation?

Your age, investment goals, risk tolerance, and investment horizon.

What are some sources of investment information?

The Internet, newspapers, business periodicals, corporate reports, and investor services.

What is liquidity in investments?

The ability to buy or sell quickly without substantially affecting the investment's value.

What types of investments are typically considered for income?

CDs, government bonds, corporate bonds, preferred and dividend-paying stocks.

What types of investments are typically considered for growth?

Common stocks, growth mutual funds, and real estate.

What is the historical return of the S&P 500 since 1926?

The S&P 500 has returned 9.8%.

What is the risk of global investment?

The risk of investing where conditions, information, costs, and regulations differ from the U.S.

What is business risk?

The risk of the business invested in failing.

What is the significance of having an emergency fund?

It provides access to funds in case of unexpected expenses.

How can small sums grow over time?

Investing small amounts regularly can lead to significant growth due to compound interest.

What is the role of employer-sponsored retirement programs?

They help individuals save for retirement through payroll deductions and often include employer matching.

What does it mean to 'pay yourself first'?

Setting aside a portion of your income for savings or investments before paying other expenses.

Why do corporations issue common stock?

To finance business start-up costs and help pay for expansion of their operations.

What does stock ownership represent?

A proportionate ownership interest in a company.

What is the difference between common stock and preferred stock?

Preferred stock usually has fixed dividends and priority claims, while common stock typically has voting rights and appreciation potential.

What are stockholders entitled to as residual owners?

Dividend income and a prorated share of the firm's earnings after all obligations are met.

What are stock returns composed of?

Price changes and dividend income.

What was the average total return on the S&P 500 from 1950-2000?

11% per year.

What are some risks associated with stock ownership?

Business risk, financial risk, purchasing power risk, market risk, and event risk.

What is par value in the context of common stock?

The stated, or face, value of a stock, mainly an accounting term.

What is market capitalization?

The overall current value of a company in the stock market, calculated as total shares outstanding multiplied by market value per share.

What is dividend income?

The return of part of the profit (earnings) of the company to the stockholders.

What is earnings per share (EPS)?

The amount of annual earnings available to common stockholders, stated on a per-share basis.

What does the dividend yield measure?

The rate of current income earned on the investment dollar, relating dividends to share price.

What is the dividend payout ratio?

The portion of earnings per share that a firm pays out as dividends.

What is a stock dividend?

Payment of a dividend in the form of additional shares of stock.

What are Dividend Reinvestment Plans (DRIPs)?

Plans where cash dividends are automatically reinvested into additional shares of the firm's common stock.

How is the Price Earnings (PE) Ratio calculated?

PE Ratio = Market Price per Share / EPS.

What is the significance of dividends increasing over time?

Dividends tend to increase as companies' earnings grow, averaging an increase of around 3% to 5% annually.

What is the appeal of investing in common stocks?

They allow investors to tailor investments to meet individual needs and provide potential for current income and capital gains.

What is the risk of low current income in stock investments?

Stocks may provide lower current income compared to other investment alternatives.

What does market value refer to in stock terms?

The current price of the stock in the stock market.

What is investment value?

The amount that investors believe the stock should be trading for, or what they think it's worth.

What challenges do investors face when predicting stock value?

Wide swings in profits and general stock market performance make it hard to predict which stocks will go up in value.

What was the average return from capital gains during the 1990s?

An average of 15.3%.

What was the return from the U.S. stock market from 2000-2010?

The market lost 1% per year.

What is the Price Earnings (P/E) Ratio?

A measure that compares the price of a stock to its earnings, calculated as market price per share divided by earnings per share.

What types of stocks typically have higher P/E ratios?

Growth stocks.

What are Blue Chip Stocks?

High-quality, financially strong stocks with stable earnings and dividends, often leaders in their industries.

What are Income Stocks?

Stocks with a record of paying higher-than-average dividends, appealing to investors seeking current income.

What characterizes Growth Stocks?

Stocks that experience high rates of growth in operations and earnings, with expectations of higher price appreciation.

What are Tech Stocks?

Stocks representing the technology sector, ranging from speculative small companies to established blue chip firms.

What are Speculative Stocks?

Stocks that offer potential for substantial price appreciation but lack a sustained track record of success.

What defines Cyclical Stocks?

Stocks whose performance is closely linked to the economic cycle, doing well in growth periods and poorly in downturns.

What are Defensive Stocks?

Stocks that tend to hold their value or perform well during economic downturns, often in staple industries.

What is the market capitalization of Small-Cap Stocks?

Less than $2 billion.

What is the market capitalization of Mid-Cap Stocks?

$2 billion to $10 billion.

What is the market capitalization of Large-Cap Stocks?

More than $10 billion.

What are the characteristics of Large-Cap Stocks?

Typically less volatile, account for a significant portion of total market value, but may lag in growth compared to smaller stocks.

What are the characteristics of Mid-Cap Stocks?

Offer greater capital appreciation potential than large-caps with less volatility than small-caps.

What are Small-Cap Stocks known for?

Potential for above-average returns or losses, often lacking a financial track record.

What is the impact of a stronger U.S. dollar on foreign investments?

It has a negative impact on foreign investments.

What is Fundamental Analysis?

A method that determines a stock's value based on the company's future earnings.

What is Technical Analysis?

A method that determines a stock's value based on supply and demand forces in the market.

What is the Efficient Market Hypothesis?

The theory that stock prices are random and reflect all available information.

What is the 'Top Down' approach in investment analysis?

An analysis method that starts with the economy, then the industry, and finally the specific company.

What is the focus of Technical Analysis?

To track stock price movements and trends using charts.

What are American Depositary Shares (ADSs)?

Shares of foreign companies traded on U.S. markets, simplifying international investment.

What are the risks associated with international investing?

Complexity due to currency fluctuations, regulatory differences, and market conditions.

What is the primary advantage of Defensive Stocks?

They provide stability and potential growth during economic downturns.

What is a characteristic of Growth Stocks regarding dividends?

They typically pay little or no dividends.

What type of stocks are often considered for steady growth potential?

Blue Chip Stocks.

What is a mutual fund?

A pooled investment of money from many investors to invest in a variety of securities.

What are the main benefits of investing in mutual funds?

Professional management and diversification.

What is the difference between closed-end funds and open-end funds?

Closed-end funds issue a limited number of shares, while open-end funds issue and redeem shares on an ongoing basis.

How are shares of closed-end funds traded?

Shares are traded on exchanges or over-the-counter like individual stocks.

What is an Exchange-Traded Fund (ETF)?

A fund that invests in securities contained in a specific index and is traded like individual stocks.

What is the primary difference between ETFs and closed-end funds?

ETFs typically use passive management to mirror an index, while closed-end funds use active management.

What does NAV stand for in mutual funds?

Net Asset Value.

How is NAV calculated?

NAV = (Value of fund's portfolio - Liabilities) / Number of Shares Outstanding.

What is a load fund?

A mutual fund that charges a sales charge when shares are purchased.

What is a no-load fund?

A mutual fund that does not charge a sales charge when purchasing shares.

What are Type A shares in load funds?

Shares that have a front-end sales charge.

What are Type B shares in load funds?

Shares that have a back-end (contingent deferred) sales charge.

What is the purpose of a mutual fund's expense ratio?

To represent all management fees, 12b-1 fees, and additional operating costs for a specific fund.

What is the recommended expense ratio for mutual funds?

An expense ratio of less than 1% is usually recommended.

What are the main categories of mutual funds?

Stock funds, bond funds, and other funds (e.g., asset allocation, balanced).

What is the Efficient Market Hypothesis (EMH)?

The theory that all available information is reflected in security prices.

What is a random walk in the context of stock prices?

The theory that stock price movements are unpredictable.

What are some advantages of mutual funds?

Diversification, professional management, ease of buying/selling, and multiple withdrawal options.

What are some disadvantages of mutual funds?

Purchase/withdrawal costs, ongoing management fees, and market risk.

What is the formula for calculating total return for mutual funds?

Total return = Income dividends + Capital gain distributions + Change in share market value when sold.

What is the role of a mutual fund prospectus?

To provide details relating to fees and fund performance.

What is the significance of the S&P 500 index in mutual funds?

It is commonly used as a benchmark for performance and is often mirrored by index funds.

What are 12b-1 fees?

Ongoing fixed fees to pay broker commissions, which can be charged by no-load funds.

What is the difference between managed funds and index funds?

Managed funds rely on the track record of fund managers, while index funds aim to replicate the performance of a specific index.

What is a contingent deferred sales load?

A declining fee charged on withdrawal based on how long you own the fund.

What are some sources of information for mutual fund investors?

The Internet, investment company websites, professional advisory services, and financial publications.