Investments Terms, Concepts, and Formulas

FUCK HOLY FUCK WHY SO MUCH

Building Wealth (3 steps)

1. Save a significant part of your income (10-20% or more)

2. Invest in a broadly diversified portfolio that promises a significant positive rate of return

3. Give your investments lots of time to grow

Asset Classes

• Cash Reserves

• Bonds

• Stocks

What are Cash Reserves

• Short term money market instruments

• US treasury bills, saving deposits, CDs

• Commercial Paper

What are Bonds

• Debt obligations over one year

• Treasury Notes, Treasury Bonds, Municipal Bonds

• Corporate Bonds

What are Stocks

Common stock is ownership of a public corporation

Historical Returns of Stocks and Bonds

Stocks have earned an average rate of return of about 12% over the past 50 years. Long Term Treasury bons have earned around 7% per year

Defined Benefit Plans

• Employer promise to pay a fixed retirement income

• Formula driven

• Employer does all the work and makes decisions

Defined Contribution Plans

• You save (tax deferred) from paychecks

• Employers may contribute too

• You make all the decisions

• Benefit depends on contributions and investment return

What is a portfolio

• Diversified (hopefully) collection of stocks, bonds, and other assets

• Individual investments are often evaluated on how they change the characteristics of the portfolio. The relationship between individual investments matters and at times can result in risk reductions

Risk

• Chance of economic loss

• Sometimes measured as a variation in return

Expected Return

• Anticipated gain of a specific period of time

• Often evaluated as compensation for taking certain types of risks

Efficient market hypothesis

Idea that every security at every point in time is fairly prices; implication is that prices are unpredictable

Controversy of the efficient market hypothesis

• Proponents

  • Most professional investors dont beat the market

  • Hard to predict the direction of stock prices

• Opponents

  • Market bubbles

  • Investment superstars

The Incentives of the Stockbroker and the mutual fund manager

• Stockbroker

  • Encourages investors to trade as they get rebates for routing customers orders to certain market makers

• Mutual fund managers

  • Have incentives to take risks to meet performance expectations

Psychology of investing

• Higher the degree of uncertainty in a decision the more emotions and psychological biases are used to help make the decision

• People tend to think of investments as better or worse.

Investment Jobs

• Brokers

• Traders

• Portfolio managers

• Financial Planners

• Investment bankers

• Security analysts

Investment industry jobs work at

• Commercial Banks

• Savings and credit unions

• Securities firms

• Investment banks

• Companies

• Credit rating agencies

• Mutual funds

• Life insurance companies

• Securities exchanges

Future Value Formula

FV = PV * (1+Interest rate)^time

Present Value Formula

Present Value = ((FV)/((1+Interest Rate)^Time))

Annuity

Fixed payment at regular intervals

What is the NYSE

• New York Stock Exchange

  • It is an Agency Auction Market

Definition of an Agency Auction Market

Market in which brokers represent buyers and sellers, and prices are determined by supply and demand

What is the AMEX

• American Stock Exchange

• Lower listings than NYSE

  • More than 1000 listings

What is the Nasdaq

It is an online negotiated market

What is a negotiated market

• Market makers are dealers

• Numerous dealers for a single security who compete for orders

• Price determination through bargaining

What is Market Capitalization (Market cap)

Market value/ Size of the firm

How to calculate market cap

Market Cap= Price per share * Number of shares

Definition of Return on Equity

Is a financial ration that measures how much net profit a company generate for each dollar of shareholders equity. Measures is the best available indictor of the firms ability to profitability use operating and financial leverage.

Equation of Return of Equity

ROE= Net Income/Avg Shareholders’ Equity

Regression to the mean

Tendency of profit rates to return toward long term industry and economy wide averages

Definition of Price Earnings Ratio

Compares a companus share price to its earnings per share to show how much investors are willing to pay for each dollar of profit

Equation of Price/Earnings ratio

P/E= Stock price/Earnings per share

Stock Quote

Offer to buy and sell shares at a specific price

Real time

Up to the minute current stock quote

Definition of Price-Weighted

ONLY the price per share matters. Used by the DJIA

Definition of Value-Weighted

ONLY the market cap matters. Most indices today including the S&P 500 index

What is the Dow Jones Industrial Average

• Consists of 30 companies

  • Most important and largest firms representing various sectors

Formula for the Dow Jones industrial average

Problems with Price-Weighted (Like the DJIA)

• Changes in high priced components (like caterpillar) move the DJIA more than low priced components.

• DJIA returns can be affected by the timing of stock splits

• Mimicking DJIA portfolio returns requires lots of rebalancing due to divisor changes

Stock Splits

Corporate action where a company increases its total number of shares while lowering the price of each individual share proportionally

What is the Standard & Poor’s (S&P)500 index

• Value weighted index consisting of 500 firms

• Value of index moves by the same percentage as the movement of the aggregated market cap of underlying components

• 500 leading U.S. based companies are chosen by S&P committee

• Not an index of the 500 largest firms, although they will tend to be larger

• Sector weights set to match overall maket

Formula for Value weighted index (Such as the S&P 500 index)

What are Russell Indices

Russell represents the largest market cap US companies, with the number being the largest amount. The 3000 is the top 3000, the 1000 is the largest 1000, but the 2000 is the 2000 smallest that are in the 3000

What is the more popular indices: Price-Weighted or Value-Weighted

Value-Weighted

Global Stock Indices

• Nikkei (Japan)

• Dax (Germany)

• FTSE (UK)

What is the Securities Act of 1933

• Applies to firms going public

• Requires firms to register with the government

• Requires firms to provide investors with financial and material information

• Exempts private placements and small issues

What is the Securities Exchange Act of 1934

• Focus on securities trading

• Creates and authorizes SEC to enfoce statutes, rules, and regulatiosn

• Protects investors against fraud

What are Self Regulatory Organizations (SRO)

• SEC delegates regulatory authority

• National Association of Securities and Dealers (NASD)

  • Regulates Nasdaq and OTC

  • Monitors sales practices

  • Administers tests and licenses for individuals

  • Ensures accurate sales information

• Municipal securities rulemaking board

• Banks- Fed reserve, comptroller of currency, FDIC

Different Market Surveillance

• NYSE Stock watch

  • Flags unusual volume and/or price changes

  • Investigates questionable trades

• Intermarket surveillance group

  • Shares information and coordinates efforts to detect manipulation

• Securities Arbitration

What are Circuit Breakers

Automatic emergency rule that temp. halts trading

Breakers are set at 10%,20%, and 30% of recent DJIA level

1. At 10%, trading halts for 30 to 60 minutes

2. at 20%, halts trading for 2 hours

3. at 30%, stops trading for the day

Definition of Primary market

Market for new securities sold to investors for the first time to raise capital to the issuer

Definition of Secondary Market

Stock exchange where investors trade stocks with each other

Definition of Round lot

100 shares

Definition of Public Float

Common stock held by unaffiliated institutional and individual investors

Definition of Market Maker

Member firm that use, its own capital to trade and hold an inventory of Nasdaq stocks

Definition of Customer order flow

Customer buy and sell activity

Definition of Market maker spreader

Difference between bid and ask prices

Formula for Dow Jones change in price

Change in DIJA= (Change in total prices)/(Divisor)

Formula for Stocks impact

Stocks impact= Stocks weight * Stocks percentage change

Definition of Bid

Highest price a market maker is willing to pay (and is lower than the ask)

Definition of Ask

Is the lowest price a market maker is willing to accept to sell

Definition of Bid-ask spread

The gap between the ask and bid quotes

What to remember about the Bid-ask Spread

• Profit goes to the market maker

• While commission are a fairly obvious cost of trading, the bid-ask spread is often viewed as the “hidden” cost of trading as the market maker is making profits on trades

Definition of Market Depth

How many people are buying and selling

Definitions of Bid Size and Ask Size

Bid Size is the number of shares offered at the bid price; Ask size is the number of shares offered at the ask price

Definition of Market Order

Instruction to buy or sell at the current market price

Definition of Limit Order

Instruction to buy or sell at a specified price

Different kinds of limit orders, and what they mean

1. Fill or Kill

   1. All or none order that must be filled exactly or not at all

2. Day Order

   1. Instruction to buy or sell during the present trading session

3. Good ‘til canceled

   1. A limit order that is open until executed or canceled by the investor

Difference between stop orders vs limit orders

• Stop orders are intended to limiting losses

• Limit Orders intended to capturing profits

Definition of Stop order

Market orders to buy or sell a certain quantity of a security if a specified price is reached or passed

Pitfalls to trading

• Active (day) trading

  • Induces the same emotions as casinos

  • Investment decisions are more likely to be influenced by emotions and psychological biases

• Allure of day trading is strong

  • People who believe they have superior information or skill feel like they should benefit by trading

• Trading costs are important

Illusions

• Illusion of Knowledge

  • The illusion that more information creates more knowledge and better predictions

• Illusion of Control

  • People often believe that they have influence over the outcome of uncontrollable events

Definition of Cash account

An account that is funded by cash, that is used to buy stocks

Definition of Margin account

Account that holds securities purchased with a combination of cash and borrowed funds

Anatomy of a Margin Account

• You can borrow money from the brokerage firm to buy more stock

• You must start with no less than 50% of the position as your equity (called initial margin)

• If the stock price falls, it is your equity that is declining

  • If your equity falls below the maintenance margin level you will be forced to sell or add more cash

Definition of initial margin

Upfront cash or collateral a trader must deposit to open a leveraged position or buy securities on margin

Definition of maintenance margin

Is the minimum amount of equity a trader or investor must keep in a margin account after buying securities or opening a leveraged position

Formula for calculating returns

Return= Gain or Loss/Amount invested

Why is borrowing able to magnify gains and losses

• Magnification of Gains

  • Increase purchasing power (from borrowing more than capital you have)

  • Higher percentage return (due to the total asset value rising)

• Magnification of Losses

  • Debt obligations (amount you borrowed and interest will have to be paid back)

  • Absorbing the full drop (any decline will come from your asset price)

Formulas for calculating equity margin or percent equity

Definition of Short Selling

The investor sells stocks that they do not own (by borrowing) and when the price falls, the stock is repurchased and returned to the broker

How does short selling work for an idiot like me

It is betting that the stock can be sold later for cheaper.

• I Borrow the stock and promise to pay it back

• I immediately sell the stock (like for $10)

• After awhile the stock becomes cheaper (like $4)

• I buy this stock back (profit $6)

• I give the stock back to the person I borrowed from

Definition of Short Squeeze

A rapid price spike in a heavily shorted stock that forces short sellers to buy back stocks, creating a chain reaction of higher prices

Impact of taxes

• Capital Gains

  • Only realized gains are taxes

  • Short term

    • Taxed at marginal income tax rate

  • Long term

    • Taxed at 20%

• Dividends

  • Taxed at 15%

• Interest Income

  • Taxed at marginal income tax rate

Difference between Roth IRA and Traditional IRA/401k Plans

• Roth IRA

  • Pay the tax now and no taxes later

  • Best when tax rates are expected to rise over time

• Traditional IRA/401K

  • Defers the taxes until the money is withdrawn in retirement

  • Best when tax rates are expected to decline over time

Definition of Initial Public Offering (IPO)

Selling shares for the first time in a new company

Different Kinds of Underwriting

• Investment Banks

  • Advise or underwrite new issues; distribute shares to institutional investors through road shorts

• Firm Commitment underwriting

  • Investment bankers buy entire issue and assume risk

• Best Efforts underwriting:

  • Investment agrees to make its best effort at placing shares; issuing firm assumes risk

• All-or-none offerings

  • Investment bank tries to sell entire issue or sale is cancelled

What is a Syndicate in Finance

Is used for large issues

• Group of underwriters

• Syndicate manager (lead underwriter)

• Underwriters allotment

• Dealers agreement: For sharing IPO fees between underwriters

The pooling of resources

SEC requirements of IPO

Securities Act of 1933- File registration statement

• Cooling off period

• Preliminary prospectus

• Effective date

• SEC may issue deficiency letter if things material changes have not been communicated to investors

• Due Diligence

• Final Prospectus

What is a Road Show

• Done by an underwriter

• Presentations to large, institutional investors

• Assess demand

• Helps to determine the best offer price

Who gets IPO shares

• Hot issue market

  • During robust markets, over 50 firms go public every month

  • Investors want these shares

  • Initial returns can be high

• Cold issue market

  • Less than 10 IPOs are issued in a month

• Who gets share?

  • Those who want ask their broker

  • When more shares are sought than are being issued priority tends to go to the brokers best clients

Definition of Margin Debt

Amount borrowed to buy or maintain a security investment

Definition of Margin Call

Brokers demand for additional collateral when the equity has declined below the maintenance margin level

Definition of Broker call rate

Interest rate charged to investors using margin debt

Definition of Short Interest

Number of shares sold short

Definition of Short interest ratio

Short interest expressed in terms of an average days trading volume

Equity Margin or Percent Equity (FOR SHORT SELL)

(equity)/(stock value)= (sale value + Cash - Stock value)/(Stock value)

Definition of Long position

It is a position in which you buy stock because you expect it to go up over time