Chapter

The Investment
2 Process

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 The Investment Process
“Don’t Gamble! Take all your savings and buy some
good stock and hold it till it goes up. If it don’t go up,
don’t buy it.”

– Will Rogers

2-2
 Learning Objectives

Don’t sell yourself short. Instead, learn about these key

investment subjects:

1. The importance of an investment policy statement.

2. The various types of securities brokers and brokerage accounts.

3. How to calculate initial and maintenance margin.

4. The workings of short sales.

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 Investing Overview
• Fundamental Question: Why invest at all?
– We invest today to have more tomorrow.
– Investment is simply deferred consumption.
– We choose to wait because we want more to spend later.

• Investors have their own investment objectives and strategies

• The Investment Policy Statement (IPS)

– Designed to reflect your objectives and strategies
– Two parts
• Objectives‫اهداف‬
• Constraints ‫قيود‬

2-4
 Objectives: Risk and Return

• In formulating‫ صياغة‬investment objectives, the individual

must balance return objectives with risk tolerance‫ تفاوت‬.
– Investors must think about risk and return.
– Investors must think about how much risk they can
handle‫ تعامل‬.

• Your risk tolerance is affected by

– Your ability to take risk
– Your willingness‫ استعداد‬to take risk

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 Investor Constraints
• Resources. What is the minimum sum needed? What are the
associated costs?

• Horizon. When do you need the money?

• Liquidity. How high is the possibility that you need to sell the asset
quickly?

• Taxes. Which tax bracket are you in?

• Special circumstances. Does your company provide any incentive?

What are your regulatory and legal restrictions?

2-6
 Investment Strategies and Policies

• Investment management. Should you manage your investments

yourself?

• Market timing. Should you try to buy and sell in anticipation of the
future direction of the market?

• Asset allocation. How should you distribute your investment funds

across the different classes of assets?

• Security selection. Within each class, which specific securities

should you buy?

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 Asset Allocation or Security Selection?
• Is asset allocation or security selection more important to the success of a
portfolio?

• Most people are inclined‫ يميل الى‬to think security selection is the more
important element for successful investing.

• Research shows, however, that asset allocation is the more important

determinant of portfolio returns. Many experts suggest:
– About 90 percent of portfolio performance stems from asset allocation.
– So, 10 percent of portfolio performance comes from security selection.

• How is this result possible? Well, consider the Crash of 2008.

– Bonds outperformed stocks in 2008
– Even those elusive ‫“ صعبة‬skilled stock pickers” might underperform bonds
• Stocks tend to move together
• Even a “skilled stock picker” would have trouble beating bonds if most stock prices are performing poorly
relative to bond prices

2-8
 Choosing a Broker/Advisor, I.
• What do you do after carefully crafting your Investment Policy
Statement (IPS)?

• After setting up your IRA (highly advised), you might decide to invest
other money.

• If so, you need to choose the type of brokerage account and your
broker/advisor from:

1. full-service brokers
2. discount brokers
3. deep-discount brokers

• These three groups can be distinguished by the level of service

provided, as well as the level of commissions charged.

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 Choosing a Broker/Advisor, II.
• As the brokerage industry becomes more competitive, the differences among broker
types continues to blur.

• Another important change is the rapid growth of online brokers, also known as e-
brokers or cyberbrokers.

• Online investing has really changed the brokerage industry.

– slashing brokerage commissions
– providing investment information
– Customers place buy and sell orders over the Internet

• Many full-service brokers offer an advisory-based relationship for clients.

– Rather than charging commissions on every transaction, the investment advisor
charges an annual fee, say 1-2%, based on the account balance.
– This fee covers all services associated with advice and trading.
– An advisory-based relationship can align the interests of the client and the advisor.

2-10
 Advisor-Customer Relations
• There are several important things to remember when you deal with
any broker/advisor:

– Any advice you receive is not guaranteed.

– Your broker works as your agent and has a legal duty

to act in your best interest.

– Brokerage firms, however, do make profits from

brokerage commissions and/or annual fees.

2-11
 Opening Your Brokerage Account
(a)Open
(a) Openaabrokerage
brokerage
ortrading
or tradingaccount
account

(b)Deposit
(b) Deposit$10,000
$10,000
intoaccount
into account

(c)Buy
(c) Buy100
100Shares
Shares
ofDisney
of Disney
at$33
at $33per
pershare
share

(d)Pay
(d) PayCommission,
Commission,
Say$50
Say $50

(e)$6,650
(e) $6,650Cash
Cash
ininAccount
Account
$3,300Stock
$3,300 Stock
InInAccount
Account
2-12
 Two Types of Brokerage Accounts

• A Cash account is a brokerage account in which securities are paid

for in full.

• A Margin account is a brokerage account in which, subject to limits,

securities can be bought and sold short on credit.

(more on selling short later)

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 Margin Accounts

• In a margin purchase, the portion of the value of an

investment that is not borrowed is called the margin.

• Of course, the portion that is borrowed incurs‫ تتكبد‬an

interest charge.
– This interest is based on the broker’s call
money rate.
– The call money rate is the rate brokers pay to
borrow money to lend to customers in their
margin accounts.
2-14
 Example: Margin Accounts,
The Balance Sheet
• You buy 1,000 Pfizer (PFE) shares at $24 per share.

• You put up $18,000 and borrow the rest.

• Amount borrowed = $24,000 – $18,000 = $6,000

• Margin = $18,000 / $24,000 = 75%

Liabilities and
Assets Account Equity
1,000 Shares, PFE $ 24,000 Margin Loan $ 6,000
Account Equity $ 18,000

Total $ 24,000 Total $ 24,000

2-15
 Margin Accounts
• In a margin purchase, the minimum margin that must be supplied is
called the initial margin.

• The maintenance margin is the margin amount that must be

present at all times in a margin account.

• When the margin drops below the maintenance margin, the

broker can demand more funds. This is known as a margin call.

2-16
 Example: The Workings of
a Margin Account, I.
• Your margin account requires:
• an initial margin of 50%, and
• a maintenance margin of 30%

• A Share in Miller Moore Equine Enterprises (WHOA) is selling for $50.

• You have $20,000, and you want to buy as much WHOA as you can.

• You may buy up to $20,000 / 0.5 = $40,000 worth of WHOA.

Liabilities and
Assets Account Equity
800 Shares of WHOA $ 40,000 Margin Loan $ 20,000
@ $50/share
Account Equity $ 20,000
Total $ 40,000 Total $ 40,000

2-17
 Example: The Workings of
a Margin Account, II.
• After your purchase, shares of WHOA fall to $35. (Woe!)

• New margin = $8,000 / $28,000 = 28.6% < 30%

• Therefore, you are subject to a margin call.

Liabilities and
Assets Account Equity

800 Shares of WHOA $ 28,000 Margin Loan $ 20,000

@ $35/share

Account Equity $ 8,000

Total $ 28,000 Total $ 28,000

2-18
 Example: The Effects of Margin, I.

• You have $30,000 in a margin account, 60% initial margin required.

• You can buy $50,000 of stock with this account (why?).
• Your borrowing rate from your broker is 6.00%.
• Suppose you buy 1,000 shares of Coca-Cola (KO), for $50/share.
• Assume no dividends, and that your borrowing rate is still 6.00%,
what is your return if:

– In one year, KO is selling for $60 per share?

– In one year, KO stock is selling for $60 per share,

but you did not borrow money from your broker?

2-19
 Example: The Effects of Margin, II.
• KO is selling for $60 per share.

• Your investment is worth $60,000.

• You owe 6% on the $20,000 you borrowed: $1,200.

• If you pay off the loan with interest, your account balance is:
$60,000 – $21,200 = $38,800.

• You started with $30,000.

• Therefore, your return is $8,800 / $30,000 = 29.33%.

• Suppose Coca-Cola stock was selling for $40 per share instead of
$60 per share? What is your return?

2-20
 Example: The Effects of Margin, III.
• Coca-Cola stock is selling for $60 per share, but you did not
borrow from your broker.

• You started with $30,000, which means you were able to buy
$30,000 / $50 = 600 shares.

• Your investment is now worth $36,000.

• Therefore, your return is $6,000 / $30,000 = 20.00%.

• Suppose Coca-Cola is selling for $40 per share instead of $60

per share. What is your return in this case?

2-21
 Example: How Low Can it Go?

• Suppose you want to buy 300 shares of Pepsico, Inc.

(PEP) at $55 per share.
– Total cost: $16,500
– You have only $9,900—so you must borrow
$6,600.

• Your initial margin is $9,900/$16,500 = 60%.

• Suppose your maintenance margin is 40%. At what

price will you receive a margin call?

2-22
Example: How Low Can it Go? (Answer)
• This will happen when the price of Pepsico, Inc. drops to $36.67.
How so? Well,

Maintenance Margin Level 

Number of Shares  P   Amount Borrowed
*

Number of Shares  P *

Solving for the critical stock price, P* , results in

Amount Borrowed
P 
* Number of Shares
1 - Maintenance Margin Level

So here,

$6,600
P*  300  22  $36.67.
1 - 0.40 0.60

2-23
 Example: Annualizing Returns
on a Margin Purchase, I.
• You buy 1,000 shares of Costco (COST) at $60 per share.

• Your initial margin is 50%.

• You borrow at the 9 percent call money rate plus 2 percent.

• You sell Costco (COST) 3 months later for $63.

• There were no dividends paid (and suppose the prices above are net
of commissions).

• What is your holding period percentage return and your EAR?

2-24
 Annualizing Returns on a Margin
Purchase, II.
Answer: First, you have to repay the 3-month loan, so t = (3/12 = .25)

Amount Repaid = Amount Borrowed × (1 + interest rate per year)t

Amount Repaid = $30,000 × (1 + .11).25
= $30,000 × 1.02643
= $30,792.90

Your Sale Proceeds = Cash from Sale – Amount Repaid

= $63,000 – 30,792.90
= $32,207.10

Your Profit = Your Sale Proceeds – Your Investment

= $32,207.10 - $30,000
= $2,207.10
2-25
 Annualizing Returns on a Margin
Purchase, III.

$32,207.10 - $30,000 $2,207.10

Holding Period Percentage Return    0.0736
$30,000 $30,000

1  EAR  (1  Holding Period Percentage Return)m

 (1  0.0736) 4

 1.3285

So your EAR is about 32.85%.

Note that there are 12/3 = 4

three-month holding periods in a
year. Therefore, m = 4.

2-26
 Other Account Issues, I.
• Trading accounts can also be differentiated by the ways they
are managed.

– Advisory account - You pay someone else to make buy and sell
decisions on your behalf.

– Wrap account - All the expenses associated with your account

are “wrapped” into a single fee.

– Discretionary account - You authorize your broker to trade for

you.

– Asset management account - Provide for complete money

management, including check-writing privileges, credit cards, and
margin loans.

2-27
 Other Account Issues, II.

• To invest in financial securities, you do not need an

account with a broker.

• One alternative is to buy securities directly from the

issuer.

• Another alternative is to invest in mutual funds.

2-28
 Short Sales, I.
• Short Sale is a sale in which the seller does not actually
own the security that is sold.

Borrow
Borrow Sellthe
Sell the Buy
Buy Return
Return
shares
shares Shares
Shares shares
shares the
the
from
from ininthe
the Fromthe
From the
shares
shares
someone
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market market
market

Today In the Future

Note that an investor who buys and owns shares of stock

is said to be “long the stock” or to have a “long position.”

2-29
 Short Sales, II.

• An investor with a long position benefits from price increases.

– Easy to understand
– You buy today at $34, and sell later at $57, you profit!
– Buy low, sell high

• An investor with a short position benefits from price decreases.

– Also easy to understand
– You sell today at $83, and buy later at $27, you profit.
– Sell high, buy low

2-30
 Example: Short Sales, I.
• You short 100 shares of Verizon Communications (VZ) at $30 per share.

• Your broker has a 50% initial margin and a 40% maintenance margin on
short sales.

• The value of stock borrowed that will be sold short is:

$30 × $100 = $3,000

Liabilities and
Assets Account Equity

Sale Proceeds $ 3,000 Short Position $ 3,000

Initial Margin Deposit $ 1,500 Account Equity $ 1,500

Total $ 4,500 Total $ 4,500

2-31
 Example: Short Sales, II.

• Verizon Communications stock price falls to $20 per share.

• Sold at $30, value today is $20, so you are "ahead" by $10 per
share, or $1,000.
• Also, new margin: $2,500 / $2,000 = 125%

Liabilities and
Assets Account Equity
Sale Proceeds $ 3,000 Short Position $ 2,000

Initial Margin Deposit $ 1,500 Account Equity $ 2,500

Total $ 4,500 Total $ 4,500

2-32
 Example: Short Sales, III.
• Verizon Communications stock price rises to $40 per share.
• You sold short at $30, stock price is now $40, you are
"behind" by $10 per share, or $1,000. (“He who sells what
isn’t his’n, must buy it back—or go to prison.”)
• Also: new margin = $500 / $4,000 = 12.5% < 40% Therefore,
you are subject to a margin call.

Assets Liabilities and

Account Equity
Sale Proceeds $ 3,000 Short Position $ 4,000

Initial Margin Deposit $ 1,500 Account Equity $ 500

Total $ 4,500 Total $ 4,500

2-33
 More on Short Sales
• Short interest is the amount of common stock held in short positions.

• In practice, short selling is quite common and a substantial volume of

stock sales are initiated by short sellers.

• Note that with a short position, you may lose more than your total
investment, as there is no theoretical limit to how high the stock price
may rise.

• Short Sellers face Constraints.

– From government intervention (i.e., the SEC)
– Also, there might not be enough shares available to borrow to short sell.
– Constraints reduce liquidity, increase volatility, and lead to inefficient
pricing.

2-34
Finding Actual Short Positions
(from finance.yahoo.com)

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 Forming a Real Investment Portfolio, I.

• Take the Risk Tolerance Quiz in the textbook.

• What score did you get?

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 Forming a Real Investment Portfolio, II.

• What does your score mean?

2-37
 Useful Internet Sites

• www.finra.org (a reference for dispute resolution)

• www.bearmarketcentral.com (a reference for short selling)
• www.nasdaq.com (a reference for short interest)
• www.moneycentral.msn.com (a reference for building a portfolio—
search the site for “Build your first stock portfolio”)
• www.sharebuilder.com (a reference for opening a brokerage
account)
• www.buyandhold.com (another reference for opening a brokerage
account)
• www.individual.ml.com (a risk tolerance questionnaire from Merrill
Lynch)
• www.money-rates.com (a reference for current broker call money
rate)
• finance.yahoo.com (a reference for short sales on particular stocks)

2-38
 Chapter Review, I.
• The importance of an investment policy statement (IPS).
– The investment policy statement (IPS) identifies the objectives
(risk and return) of an investor, as well as the constraints the
investor faces in achieving these objectives.
– The IPS provides an investing “roadmap” and will influence the
strategies, type of account, and holdings an investor chooses.

• The various types of securities brokers

– Choosing a Broker
– Online Brokers
– Security Investors Protection Corporation
– Broker-Customer Relations

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 Chapter Review, II.
• Brokerage Accounts
– Cash Accounts
– Margin Accounts and how to calculate initial and
maintenance margin
– A Note on Annualizing Returns

• Short Sales
– Basics of a Short Sale
– Some Details

• Forming a Real Investment Portfolio

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