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Introduction to Investments: Stocks, Bonds, and Cash

Explore the three main asset classes in investments - cash, bonds, and stocks. Learn about their historical performance, inflation and taxes, comovement and correlation, and the role of equity-related market institutions.

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Introduction to Investments: Stocks, Bonds, and Cash

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  1. A First Look at Investments Chapter 7

  2. Chapter 7 Outline 7.1 Stocks, Bonds, and Cash, 1970–2007 7.2 A Brief Overview of Equity-related Market Institutions

  3. A First Look at InvestmentsStocks, Bonds, and Cash: 1970 to 2007 • Three Asset Classes: Cash, Bonds, and Stocks • Cash – Liquid, low-risk, short-term debt securities, CDs, saving deposits, commercial paper. • Bonds – Debt securities with longer maturities (government, corporate). • Stocks – Grouped by size or other characteristics Large-caps Largest 500 as in S&P 500 Mid-caps Middle-ranked stocks by size Small caps Smallest size Industry Grouped by business segment Style Value vs. growth stocks Fundamentals Dividend payers • Other asset classes may include art, real estate, commodities, foreign investments, natural resources, and currency (and really cool cars).

  4. A First Look at InvestmentsRepresentation of Historical Returns: 1970 to 2007 FIGURE 7.1 The Time Series of Rates of Return on the S&P 500, 1970–2007

  5. A First Look at InvestmentsDistribution of Historical Returns: 1970 to 2007 FIGURE 7.2 The Statistical Distribution Function of S&P 500 Rates of Return, 1970–2007

  6. A First Look at InvestmentsCompounded Rates of Returns: 1970 to 2007 FIGURE 7.3 Compound Rates of Return for the S&P 500, 1970–2007

  7. A First Look at InvestmentsHistorical Investment Performance: 3 Asset Classes TABLE 7.1 Comparative Investment Performance, 1970–2007

  8. A First Look at InvestmentsHistorical Investment Performance: 4 Stocks TABLE 7.1 Comparative Investment Performance, 1970–2007 (Cont.)

  9. A First Look at InvestmentsStocks, Bonds, and Cash: Inflation and Taxes • Inflation is a banker’s worst nightmare. Should it be yours? Yes, if you save. • A dollar invested at the federal funds rate in 1970 returned $11.03 by 2007; however, inflation rose four-fold. Thus the $11.03 was worth $5.57 in 1970 dollars. • If you invested in bonds or stocks and paid taxes at the highest tax bracket, your bond return of $24.37 would have become $18 after-tax. If you had instead invested in stocks, your return of $48.63 would have become $35 after-tax. • It is said that paying large amounts of tax can make you vote Libertarian or at least consider moving to the Virgin Islands to preserve capital. 

  10. A First Look at InvestmentsStocks, Bonds, and Cash and Inflation

  11. A First Look at InvestmentsComovement, Beta, and Correlation • Stocks tend to move with the market. This tendency is correlation and comovement at work. • Correlation tells you direction as in “same” vs. “opposite” direction. Comovement includes correlation with the amplitude of movement. • We can quantify comovement as the slope of a line plotting stock returns vs. market returns. This slope is called the market beta of the stock. Beta orSlope Characteristic Negative Security up when market down Near zero Security acts like a T-bill; market doesn’t matter Positive Security up when market up • Securities with negative betas can hedge a portfolio. This allows us to reduce risk, which allows us to sleep at night.

  12. A First Look at InvestmentsThe Big Picture • History tells us that stocks offered higher average rates of return than bonds. • History tells us that bonds offered higher average rates of return than cash. • History tells us “beware the average”…… ……some years the opposite is true: Cash is king! • History tells us individual stocks were more risky; cash was least risky. • Risk is rewarded with return -- typically, higher risk receives a higher return. However, holding lots of risk can ruin your portfolio and a night’s sleep. • Portfolios of many stocks have less risk than individual stocks. This characteristic is called “diversification.” • Positive average returns usually translate to positive compound returns. • Stocks tend to move together, while cash does not move with the market. • Market correlation with cash was about 0%; with bonds about 25%; and with individual stocks, 40% to 70%.

  13. A First Look at InvestmentsWill History Repeat Itself? • Depends on what period of time you call history. To make informed choices, investors and firms need to consider many years of history. • It is difficult to predict the next year’s rate of return. • Even with 30 years of history, you can never be certain. • Historical information increases the forecasting power of your estimates, but don’t be blind to reality. • What history matters? • Historical risk: Correlations and standard deviations tend to be stable. • Historical mean reward: Historical average rates of return are not good predictors of future expected rates of return. • Realizations: Historical results are poor predictors of future results. • Historical statistics are only an imperfect guide to the future.

  14. A First Look at InvestmentsA Brief Overview of Equity-Related Market Institutions • Retail Brokers • Take buy and sell orders. • Orders can be at market, limit, stop-loss, GTC, fill or kill. • Route orders to exchange or electronic network for trades. • If executing trades is the first function of a broker, 2nd is recordkeeping. • Provide funds for borrowing on margin. • Locate stocks for short sales by clients. • Prime Broker • Handles only the last three above, and lets clients execute their own orders. • There are full service brokers, discount brokers, and online brokers, all of which have different trading fees and offer different services to clients.

  15. A First Look at InvestmentsBrief Overview of Equity-Related Market Institutions • Exchanges and Non-Exchanges • Centralized trading locations (NYSE and NASDAQ). • NYSE uses specialists and electronic trading to fill orders. • NASDAQ is solely electronic, globally accessible, with no physical place. • Market makers in a stock can observe the limit-order book to see bids. • NYSE is older and larger with 3,000 firms worth $25 trillion. • NASDAQ is younger; lists many firms that tend to be smaller, technology firms. • Our markets trade “continuously” during open hours. • Some foreign markets trade non-continuously or “by appointment.” • Non-continuous markets trade when enough orders accumulate. • ECNs are electronic communications networks designed for trades. • Exchanges have merged and bought other exchanges and ECNs. • Crossing systems match orders for large institutions (POSIT, Liquidnet). • OTC, over-the-counter, markets trade pink sheet stocks, options, bonds, etc. • U.S. investors have more access to foreign exchanges, but costs are higher.

  16. A First Look at InvestmentsInvestment Companies (3 Types) • Investment Companies: Unit Investment Trusts, Mutual and Closed-end Funds • Unit Investment Trust holds other securities and cannot trade these securities actively. • ETFs (exchange-traded funds) hold a basket of securities. • UITs are traded on exchanges. • UIT shares can be traded for a proportion of the actual holdings of the UIT. • UITs trade near their asset values at all times, or arbitrage would occur. • Mutual Funds are open-end investment companies that hold securities that may be actively traded by the fund’s managers. • Mutual funds do not trade on exchanges but rather through brokers or directly from the fund. • Mutual funds can invest on style, theme, or whim. • Closed-end Funds do not allow direct exchange between investors and the fund for the underlying assets. • A closed-end fund can hold more illiquid securities than a mutual fund. • Closed-end fund values can deviate from their asset values.

  17. A First Look at InvestmentsHow Securities Appear and Disappear: Inflows • Inflows • Most securities list on an exchange with an IPO (initial public offering). IPO is the first time shares are sold to the public and institutions. • Large investment banks underwrite the offering at a fixed price. • Average first day return for an IPO is 10%. • Average percentage of equity sold is 33 1/3%. • Typical IPOs sell $20M to $100M in shares, but Visa was $20B. • Percentage of IPO firms that fail or wither: 66%. • Surviving firms issue more stock in seasoned equity offerings. • Alternative to IPO is a reverse merger, where a private firm buys a publicly held firm. • Regulation: • SEC, Investment Advisers Act of 1940, Securities Exchange Acts.

  18. A First Look at InvestmentsHow Securities Appear and Disappear: Outflows • Outflows • Dividends are a means to transfer money out of the financial markets. • Share repurchases transfer money out of the markets with a tax angle. • Delisting is one way a firm leaves the public financial markets. • Bankruptcy can end a firm’s life in the financial markets. • Liquidation can occur if the firm is financially distressed. • Some healthy firms may liquidate assets and return the cash to investors. • Limited liability protects investors when firms go bust. • Taxes impact a firm’s decision on how to return capital. • Most share repurchases are tax efficient when compared to paying dividends. • Yet, firms still like to pay dividends. Some things never change….much.

  19. Chapter 7 Additional Chapter Art

  20. FIGURE 7.4 Rates of Return on the S&P 500 and PepsiCo (PEP), 1970–2007

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