Forbes Guide to the Markets E-Book

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 366

Veröffentlichungsjahr: 2009

Beschreibung

From the leader in financial information, a fully updated guide to investing in today's markets This accessible book is a practical guide to the financial markets. Designed to help both the new and experienced investor gain sufficient understanding and knowledge to invest wisely and confidently in today's turbulent markets, it covers all the elements necessary to become financially street smart-from products, players, and procedures to rules, regulators, and risk/reward trade-offs. Filled with solid investment principles, the Forbes Guide to the Markets, Second Edition is completely revised and updated to reflect new trends and changes in the markets. * New topics discussed include the introduction and implementation of ETFs, the role of hedge funds, and the effects of the subprime crisis * Updated and revised chapters contain buying and selling techniques, fundamental, technical and quantitative analysis, and futures and options information * Highlights key terms and contains a complete glossary An essential resource for both the new or seasoned investor, this authoritative resource is a must-read for anyone aspiring to become a savvy investor.

Leseprobe

Table of Contents

Title Page

Copyright Page

Acknowledgements

Note to the Reader

About the Author

Introduction

Section One - Establishing a Frame of Reference

Chapter 1 - FROM “DUMB” BARTER TO INTELLIGENT AGENTS

Chapter 2 - POINT-COUNTERPOINT

Stocks

Mutual Funds

Bonds

ETFs

Options

Futures

Summary

Chapter 3 - CONFRONTING INFORMATION OVERLOAD

Investor Constraints

Investor Choices

Investor Safety

Section Two - Stocks and Equity Markets

STOCKS AND EQUITY MARKETS

Chapter 4 - VARIETIES OF STOCKS

Just What is a Security, Anyway?

Issuers and Underwriters: Why Does a Corporation Sell Stock to the Public?

Why Investors Buy Stock

Summing Up Total Return: Dividends and Capital Gains

A Letter to Our Shareholders: Annual and Quarterly Reports (and Filings)

Making Sense of Types, Classes, and Other Stock Categories: A Map of the World ...

Chapter 5 - STOCK MARKETS

The Big Board

The Incredible Growth of Trading and Capital

National Association of Securities Dealers Automated Quotation System (Nasdaq)

Technology, Dark Pools, and the Evolution of a Unified Market

Chapter 6 - THREE VIEWS OF THE NUMBERS

Fundamental Analysis

Technical Analysis

Quantitative Analysis

Chapter 7 - WHERE TO FIND INFORMATION ON STOCKS AND FINANCIAL MARKETS

A Selection of Information Sources on the Financial Markets

Chapter 8 - HOW TO BUY AND SELL STOCK

Full-Service Brokers

Discount Brokers

Financial Intermediaries

Direct Purchase

If It Sounds Too Good to Be True . . . Protecting Yourself from Stock Scams

A Note on Financial Planners

Section Three - Mutual Funds and Investment Companies

MUTUAL FUNDS AND INVESTMENT COMPANIES

Chapter 9 - A HISTORY AND OVERVIEW OF THE MUTUAL FUND BUSINESS

Open-End versus Closed-End Funds

Index Funds

Load versus No-Load Funds

Chapter 10 - ADVANTAGES OF MUTUAL FUNDS

Simplicity

Diversification

Access to New Issues

Economies of Scale

Professional Management

Indexing

Chapter 11 - DISADVANTAGES OF MUTUAL FUNDS

Impact of One-Time Charges and Recurring Fees on Fund Performance

Hidden Cost of Brokerage

Some Hidden Risks of Fund Ownership

Chapter 12 - SOURCES OF INFORMATION ON MUTUAL FUNDS

Investment Company Institute Classification of Types of Funds

Lipper Analytical Services

Forbes

Morningstar

Chapter 13 - ALTERNATIVE INVESTMENTS

Hedge Funds

Funds of Hedge Funds

Other Alternatives

Section Four - Bonds and Other Fixed-Income Securities

BONDS AND OTHER FIXED-INCOME SECURITIES

Chapter 14 - SEVEN CHARACTERISTICS OF BONDS

The Lifespan of Bonds

Interest versus Discount

Relationship of Price to Yield

Four Important Yield Measures

Credit Quality, Ratings, and Insurance

Call and Related Features

Fixed versus Floating Rates and Foreign Currencies

Chapter 15 - HOW THE OTHER $30 TRILLION IS INVESTED

Treasuries

Corporates

Mortgage-Backed Securities and Other Asset-Backed Securities

Municipals

Money Market

Summary

Section Five - Options, Futures, and Other Derivatives

OPTIONS, FUTURES, AND OTHER DERIVATIVES

Chapter 16 - OPTIONS

Exchange-Traded Options

Combination Strategies

Determining the Value of an Option

Chapter 17 - FUTURES

A Seller’s Need to Hedge . . .

Some Buyers Need to Hedge, Too

Speculation or Insurance? Maybe a Little of Both

Actuals versus Cash-Settled Contracts

Margin and Collateral

Chapter 18 - OTHER DERIVATIVES

Section Six - Summing Up Risk and Return

SUMMING UP RISK AND RETURN

Chapter 19 - HOW WELL ARE MY INVESTMENTS DOING?

The Basics of Return

Annualized Returns: Arithmetic (Simple) or Geometric (Compound)?

Time-Weighted Returns versus Money-Weighted Returns

Complicating Factors

Chapter 20 - COMING TO GRIPS WITH THE MANY DIMENSIONS OF RISK

A Definition of Investment Risk

The Relativity of Risk

What Is Market Risk?

“It Will Fluctuate”

Other Kinds of Investment Risk: From the Quantifiable to the Subjective

Balancing Risk and Return

Chapter 21 - A CRESCENDO OF CHANGE

Again, We Ask, What Is a Market?

Glossary

Index

Copyright © 2009 by Forbes LLC. All rights reserved.

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Library of Congress Cataloging-in-Publication Data

Groz, Marc M.

Includes index.

eISBN : 978-0-470-52294-3

1. Capital market. 2. Stock exchanges. 3. Mutual funds. 4. Bond market. 5. Over-the-counter markets. I. Title.

HG4523.G76 2009

332.63’2—dc22

2009007454

Acknowledgments

Many people helped in the creation of this new edition. First of all, I would like to thank my editors at Forbes (Vahan Janjigian and Barbara Strauch) and Wiley (Laura Walsh) for all their help and encouragement. I would also like to thank Anastasia Skoybedo and Chris Reich, my research interns at Topos, for their indefatigable fact-checking and service as “Emperor’s Wardrobe Consultants” extraordinaire.

In the 10 years that have elapsed since the first edition of this book was published, many investment and other professionals have generously shared their knowledge, helping to shape this new edition. Special mention must go to: Ifty Ahmed, Reuven Brenner, Don Brownstein, Sanjeev Daga, Emanuel Derman, Asami Ishimaru, Tom Kyle, Jon Lukomnik, David McClean, Bill Overgard, Richard Rosenfeld, Jason Ruspini, Neil Strumingher, Michael Trenk, Jan van Eck, and Walt Weissman.

Extra special thanks goes to my wife, Robbin Juris, whose companionship is beyond measure. This book is dedicated first of all to her; it is also dedicated to my parents, who instilled in me a lifelong love of reading and writing; and, last but not least, it is dedicated to my boys: Gabriel, who was an infant during the writing of the first edition and is rapidly becoming an amazing young man; and Zachary, born three days after the attacks of September 11, 2001, an amazing kid without whom I might not be here at all.

Note to the Reader

The world of financial markets has its own special language. To help familiarize you with this language, we will highlight key financial market words and phrases in bold type, as they are discussed. Many of these terms are defined in the text, or in brief “side bar definitions” along the side of the page. For ease of reference, or to refresh your memory about what something means, the glossary at the end of the book contains all of the definitions provided in the text.

About the Author

Marc Groz is a leading authority on financial markets. He has developed investment strategies for two top-ranked investment funds and served as chief risk officer for two multi-billion dollar hedge funds. He is managing member of Topos, an asset manager and risk advisory firm.

Marc’s views on the markets have been quoted by The Financial Times, The Wall Street Journal, Barrons, Risk, Reuters, TheStreet.com, MarketWatch. com, Forbes.com, Business Week, and The New York Times. He has appeared on CNBC, Fox Business News, Bloomberg (radio and TV), and BBC-TV Worldwide.

He has lectured widely to diverse audiences, ranging from his students at New York University to members of the International Association of Financial Engineers. He has moderated panel discussions on financial innovation with Yale University professor Robert Shiller and regulatory reform with Connecticut Attorney General Richard Blumenthal.

Marc’s interest in how things really work spans decades. After achieving Honors in the Westinghouse (Intel) Science Talent Search, Marc was accepted at the age of sixteen by Harvard, M.I.T., and Columbia. He attended Columbia University as a John Jay National Scholar, graduating with honors in 1979 (Math/Psych). He did graduate work in mathematics, studying with the world-renowned algebraist Samuel Eilenberg. He was recipient of the W.W. Cumming Prize in Psychology.

Marc is the owner/inventor of patented and patent-pending financial instruments, gaming systems, valuation methods, and mechanisms for protecting privacy in the digital age. He is married and has two sons.

Introduction: Becoming a Savvy Investor

“The times are changed, and we change with them.”

—Roman proverb

What a difference a decade makes! Ten years ago, when the first edition of Forbes®Guide to the Markets was published, the global economy was booming. “Dot com” was the watchword of the day—everybody wanted to work for one. “Dow 36000” was supposed to be just around the corner.

Today, the global economy is suffering. Bad news is everywhere. Everybody just wants to keep their job. We’re closer to Dow 3600 than Dow 36000. Some argue that economic conditions are akin to the Great Depression of the 1930s. Others see the buying opportunity of a lifetime, arguing that the prices of assets have fallen far below their true value. A third group sees some great opportunities amidst the carnage, but expects years to pass before the markets get back to normal.

How does one go about investing in times like these? Will things ever get back to normal? What is “normal,” anyway?

This question calls for some serious detective work, as practiced by a serious—if fictional—detective: Sam Spade. In The Maltese Falcon, Spade confronts the case of a man who disappeared apparently without any cause: “a man named Flitcraft.” It turns out that Flitcraft who, by all accounts had a great life, had simply disappeared: “‘He went like that,’ Spade said, ‘like a fist when you open your hand.’”

Spade first learns of the case five years after the disappearance; it turns out that Flitcraft had been walking to lunch and passed a construction site that had just the skeleton of an office building. “A beam or something fell eight or ten stories down and smacked the sidewalk alongside him . . . a piece of sidewalk was chipped off and flew up and hit his cheek . . . he still had the scar when I saw him. . . .”

Spade continues, “He was more shocked than frightened. He felt like somebody had taken the lid off life and let him look at the works.” This, it turns out, accounts for Flitcraft’s sudden disappearance. Though he “had been a good citizen and a good husband and father,” he knew now that men “lived only while blind chance spared them.”

I will come back to Spade’s story in a moment, but first we need to take a detour and talk about a close relative to “blind chance,” the concept of risk (a subject that deserves and has its own chapter). The financial crisis has brought the concept of risk to the center of investors’ collective awareness. In happier times, people focus on the expected return on their investments. Today, as Will Rogers once said, “I’m not so much concerned with the return on capital as I am with the return of capital.”

As a former chief risk officer of two multi-billion dollar hedge funds, I have thought a great deal about risk. From my perspective, it is important to recognize that risk changes over time, along with people’s perspective about it. From this standpoint, there was plenty of risk around in the late 90s, but it appeared in a different form—risk of losing ground against one’s peers, of not “keeping up with the Joneses.” Later, after the Internet bubble burst, the fear of losing what one had came to dominate the fear of not getting more.

Still later, as the housing bubble inflated in this decade, a new fear of missing out (and desire to profit) came to dominate. By early 2009, however, the collective risk profile of investors had transformed yet again, with ready cash valued as highly as “dot com” stock options were a decade earlier.

As we can see, a society’s ideas of “normal” or “expected” evolves over time. Ten years ago, at the end of a long secular bull market, most Americans were too young to remember the Great Depression of the 1930s. Many had grown up or were born after the stagflation of the 1970s. It was all too easy for the hard-earned lessons of those times to be written off as ancient history. From the standpoint of 2009, we are led to wonder: “What will the world look like in five or ten years? What existing data and theories are relevant to us as investors?”

These are excellent questions, for which there are no simple answers (which is probably the definition of an excellent question). The truth is that investors should always ask themselves which data and theories are relevant right now, and which are noise that should be ignored. In easier times, these questions tend to be given short shrift. Today, the opposite danger lurks, the danger of too much uncertainty leading to inability to make decisions—which can lead to significant regret over missed opportunities down the road.

As investors, we must strive to keep an emotional equilibrium conducive to intelligent decision making; we mustn’t yield to the twin temptations of impulsiveness and procrastination. We must “make haste slowly”!

In this spirit, I invite you to read the new edition of Forbes® Guide to the Markets. It has changed with the times, yet strives to reveal what is unchanging in markets—and in human nature.

So what became of Flitcraft? After the accident he disappears, wandering around for a few years, eventually settling down again and re-establishing a normal life like the one he’d had prior to the falling beam. As Spade tells it, “he had settled back naturally into the same groove he had jumped out of . . . that’s the part of it I always liked. He adjusted himself to beams falling, and then no more of them fell, and he adjusted himself to them not falling.”

—MARC M. GROZStamford, ConnecticutApril 25, 2009

Section One

Establishing a Frame of Reference

Chapter 1

FROM “DUMB” BARTER TO INTELLIGENT AGENTS

A Genealogy of Markets

Where did financial markets come from? What distinguishes financial markets from other forms of trade? How do financial markets work? We will briefly address the first two questions in this introduction; answering the third question is the goal of this book.

Markets for the purchase and sale of financial securities such as stocks and bonds have existed for hundreds of years. Typically, these markets began with a small group of men (and maybe a few women) who met informally at a coffeehouse or restaurant to act as intermediaries between buyers and sellers of securities (here we’re talking pieces of paper). As the volume of their business increased, these loose-knit groups formed associations with rules of conduct. In London, for example, The Stock Exchange was established in 1773 in a room in Sweeting’s Alley. The building became known as The Stock Exchange Coffee House, still showing the link to its former home, a coffeehouse named Jonathan’s located in Change Alley.

securities

Paper or computerized documents expressing financial claims to an issuer’s assets; abstractly, the claim itself, independent of the form in which it is represented.

Nineteen years later, in 1792, a small group of New York stockbrokers, who had been trading under an old buttonwood tree on Wall Street since the days following the Revolutionary War, signed a business agreement. Twenty-five years later, in 1817, the Buttonwood Group created an association—The New York Stock and Exchange Board—and arranged to move indoors.

What Is a Security?

Securities are usually thought of as the pieces of paper that prove ownership (stock certificates), ownership-related rights (option or warrant certificate), or a creditor relationship (bond certificates). Most of these pieces of paper, however, no longer exist, having been replaced by book entries in electronic form. Some dictionaries dodge the question neatly, defining securities as “financial instruments” and leaving it at that. In the United States, securities are more narrowly defined as a subset of financial instruments that pass what is called the Howey Test. Like Gaul, the Howey Test is divided into three parts: (1) money must be invested in a business; (2) where there is the expectation of a profit; (3) with no effort required on the part of the investor.

This still leaves us in want of a definition of financial instrument. We will define financial instruments as rightful claims to assets represented in some fashion, whether on paper, in a computer’s memory, or in any other verifiable way. Defined in this way, the financial instrument still exists even if the certificate is lost or the computer crashes.

Under the Old Buttonwood Tree: The First Trading Post

The tree that started it all was a buttonwood tree, Platanus occidentalis. According to the New York Stock Exchange, the tree was located near the eastern end of Wall Street, on the north side of the street between Pearl and William Streets. How tall a tree was it? Some buttonwood trees grow to 150 feet. How old a tree was it? It is thought to have been a seedling a century before Columbus’s voyage of discovery. Many of its neighbors were felled by British axes when Manhattan was occupied during the Revolutionary War. The buttonwood survived, becoming a popular place for brokers and other traders to gather.

As to the legend itself, did 24 brokers meet beneath this tree on May 17, 1792, to sign the Buttonwood Agreement? The prevailing view is that the agreement was signed indoors, at a local hotel. One thing is certain: Whether the signing under the tree was literally true or a fanciful fable, the agreement has borne plentiful fruit.

What distinguishes financial markets from nonfinancial markets? Financial markets can be seen more clearly if placed in the larger context of markets in general. Markets, in turn, are more easily understood if looked at in the still larger context of forms of trade between individuals and groups.

Both market and nonmarket forms of trade are as old as civilization. Both have existed even in cultures that traded goods without the use of money. Nonmonetary trade has taken many forms, most notably barter (i.e., exchange of goods and/or services for other goods and/or services) and various forms of ritualized gift giving. Extensive barter markets existed in Ancient Egypt and in Mesopotamia 5,000 years ago.

An early type of barter trade that required neither money nor even a shared language is mentioned by Herodotus, the Ancient Greek historian known as the Father of History. Writing nearly 2,500 years ago, he tells of Carthaginians engaged in “dumb barter” with tribes from beyond the Pillars of Hercules. Also known as “depot trade,” or “silent trade,” the widespread custom was practiced at one time or another in such diverse places as northern Russia, western Africa, Sumatra, and India. It worked roughly as follows.

One of the parties to a silent trade went at the appointed time to the traditional spot designated for trading (how these times and places were selected we do not know). The first party set down the goods being offered and then retreated to another location, signaling the other party with a call or other sound. On hearing the signal, the second party went to the spot, placing items considered of equal value alongside the items offered by the first party. Then that individual, too, retreated, allowing the first party to return and look over the wares offered by the second party. At this point the first party either completed the trade by removing the second party’s wares or, if not satisfied, left those wares in place until the second party sweetened the offer with additional goods.

Did this type of barter constitute a market? It appears that markets require, at minimum, some goods or services for sale and a means for traders to place bids and make offers on these goods with other traders. Thus “dumb” barter does possess two of the salient features of markets: items for sale and the establishment of a fixed time and place for traders looking to make deals.

But it takes more than fixing a time and a place to constitute a market and to distinguish it from other kinds of trading. It takes only two to trade, but markets need at least three participants. This gives the participants the ability to compare what is being offered (and/or asked for) by one party with what is being offered (and/or asked for) by another. Dumb barter does not provide a means to look for a better deal from a different trader; there are only two parties to the trading. It does not even require a common language. On this reckoning, it falls short of being a true market.

Notice that in the preceding paragraph we studiously avoided the terms buyer and seller. That is because, in the absence of money, there is no clear distinction between buyers and sellers: Each party is a little bit of both. While this lack of distinction between buyers and sellers might seem to be an artifact of primitive societies, we will see in Chapter Sixteen (on options) that a curious aspect of the Information Age is a form of trading known as swaps, in which the distinction between buyers and sellers is once again blurred.

The creation of barter markets was an important development in human history. Even so, its limitations are readily apparent. In a barter market, a potential buyer may not have the item that a potential seller wants. Alice may have almonds that she wants to trade for butter. Bob may have butter but needs chocolate. Charlie, who has chocolate, wants almonds. In order for Alice to get butter, she must first get chocolate (see Table 1-1). In the absence of a medium of exchange, even a simple shopping expedition can require a high degree of knowledge of the marketplace. Furthermore, buyers and sellers find it difficult to calculate prices when restricted to barter.

It is wasteful to have to engage in multiple transactions in order to get a single needed product. Not only can this type of barter be complicated, but to complete a transaction, a trader may need a great deal of information about price and availability of products he or she doesn’t want and about the needs of other traders.

Table 1-1 A Comparison of Barter and Money-Based Trading

or

Money-Based Trading

Even with only three people trading three products, barter can be complicated. This complexity increases exponentially with the number of products and services being traded. In a growing economy, with thousands of products and services, barter is a less and less efficient means of trade. At some point along the way, a barter system becomes unworkable. Something has to change. In the language of the theory of complex systems, a critical point has been reached. At that point something new emerges.

That something new is money. Consider Dave the banker. Dave has dollars. Instead of everyone running around in circles trying to complete increasingly labyrinthine transactions, they go to Dave and get dollars in exchange for their goods. Now, with Dave’s dollars serving as a universal medium of exchange, Alice can sell her almonds directly to Charlie and buy butter directly from Bob.

Where Do Dollars Come From?

The word dollar originally entered the English language as the name of a sixteenth-century Bohemian silver coin, the taler or thaler, shortened from Joachimstaler, named after Joachimsthal, a town in Bohemia. Later, dollar was used to refer to the Spanish peso, or piece of eight, a coin used not only in Spain but in North America, and in widespread use at the time of the American Revolutionary War. From piece of eight we get the value of a quarter as two bits, long before the word bit—a contraction of binary digit—became associated with computers.

The emergence of money provides both a medium of exchange and a common denominator that enables traders to compare the various goods (or services) offered. Initially, this was done by selecting one item to be the standard of comparison.

With a universal medium of exchange operating in a market, the ability to discover price emerges. At any given time and place, a unique price is created for items on sale in a market. This price is sometimes called the equilibrium price, because it is the price that theoretically equalizes supply and demand. In practice, this equilibrium may not be so obvious or stable. One reason for this is that the exchanges that are supposed to set the equilibrium price are hypothetical, not actual, trades. When real trading commences, it may be affected by influences not taken into account by theory, such as the continual introduction of new products and services that compete with existing wares and the periodic revolutionary changes wrought by the emergence of new forms of trading.

Money simplifies transactions by providing a universal intermediary for goods and services. But it also serves other important purposes. Thousands of years ago, human societies began to move away from prehistoric subsistence economies in which little was produced beyond the bare necessities of life. Cities emerged, and with them came economies that produced a surplus. In these long-ago times, money began to function as a means of representing that surplus.

Money Changes Everything

The word money comes from an epithet applied to the Roman goddess Juno. She was referred to as Juno Moneta. In addition to money, the words monetary and mint are also derived from that epithet. In fact, the temple of Juno Moneta was the Roman mint.

When the surplus is invested (put to use in a productive enterprise), it is known as capital. When used as capital, money is not only a convenience for facilitating transactions, but is an essential means of organizing complex projects and enterprises.

capital

Surplus goods and/or money used to create more goods and/or money.

The ability to invest money gave rise to a multiplicity of new kinds of wealth. The existence of multiple currencies gave rise to a new kind of transaction. Beyond barter, where goods and/or services are exchanged, and beyond the purchase or sale of goods and services, a purely monetary transaction could now take place, with one kind of money being exchanged for another kind—in essence, exchanging symbol for symbol. In these purely financial transactions, we can see the beginnings of the financial markets.

Trade has developed in two independent, yet related, ways. First, it has grown more and more abstract. Second, it has grown to include larger and larger groups of people. The increasingly abstract nature of trading has fed its tendency to include larger and larger groups, while the involvement of larger and larger groups has reinforced the abstract nature of trading.

The details of how potential participants interact with each other varies from market to market, as does the amount and quality of information exchanged. There is also considerable variation in ownership and control of markets.

We can visualize the history of commerce as an increasingly specialized and complex hierarchy of trading. As we have seen, the simplest kind of trade requires neither money nor market, nor even language. Language makes it possible to negotiate over price and terms, leading to the kind of barter arrangements that exist today. When these are organized into a market, pricing is no longer simply a matter of two-way negotiation, but is derived from the interaction of supply and demand on the part of market participants. We can also have nonmarket trades that involve money. The combination of money and markets leads to still more elaborate forms of trading—and thus to the beginnings of financial markets.

Markets have become so widespread and popular that it is becoming hard to imagine a social order without well-developed markets. Yet it is helpful to recall that until very recently, markets were anathema in many parts of the world. In the former Soviet Union, in Communist China, and in other places, many forms of markets were illegal. The official line was that a “command economy” was best, with centralized planning and sharp limits on what could be bought and sold and who could buy and sell it.

Intelligent Agents: Computer Programs as Financial Intermediaries

The evolution of computer networks has given rise to a qualitatively different kind of program usually known as an intelligent agent (also referred to as smart agents or bots, short for robots). These programs operate autonomously, according to guidelines you specify. If you have used an Internet search engine to locate information or a web site, you have already used an early form of this technology. Intelligent agents go one step further than search engines. They do not merely find a piece of information or a web site for you. They negotiate transactions with counterparties, usually other intelligent agents. Still in an early phase of development, intelligent agents hold the promise of allowing investors to specify guidelines and let the software do the negotiating.

Until recently, the use of barter was a very strong component of the Russian economy. Elaborate barter networks operated in a virtual economy, hiding the true extent of Russian economic activity and preventing the government from collecting taxes. By some estimates, as much as two-thirds of that economy was barter-based. In the aftermath of the financial and economic crises of 2008, we may be observing a resurgence of barter on a global scale, to supplement or replace broken financial systems.

Sophisticated commodities trading with future delivery of goods requires that traders develop the capacity to understand the time value of money. From here it is but a short step to the issuance of bonds and other debt securities, and to their trading. This develops both in the open marketplace and behind closed doors. In either case, technology facilitates the creation and distribution of more and more abstract forms of financial instruments. The constant evaluation of these instruments by buyers and sellers exerts a kind of evolutionary pressure on the whole complex system made up of stocks, markets, and the organizations and individuals who use them. Thus the cycle of innovation continues, from the dumb barter of ancient history to the intelligent agents at the cutting edge of today’s financial technology.

Chapter 2

POINT-COUNTERPOINT

Six Investment Approaches

How should you invest your money? There’s no shortage of opinions on the subject, no shortage of advice. All too often, however, such opinions and advice are based on a selective presentation of the facts, perhaps colored by the advice-giver’s motives and affected by day-today news and fads.

One person will tell you that stocks are the solution. Another will insist that mutual funds give you the most for your money. A third will tell you to bet on bonds. Others will espouse exchange traded funds (ETFs), opt for options, or become fascinated by futures.

Investing is not just a theoretical exercise. You have, or will have, money that you want to invest. In fact, need is probably a more accurate word. You need (or will soon need) to invest the money that you have earned, saved, and/or inherited so that you can meet your financial goals, responsibilities, and commitments. And you would like to understand as much as possible about this sometimes confusing but vitally important subject.

So, how should you invest your money? As a warm-up for our voyage through the world of financial markets, we’ll begin by looking a bit more closely at some of the most common answers to this question. Then we’ll take you, one step at a time, through what you need to know in order to arrive at your own answer—the one that is best for you.

Stocks

Many market advisors urge investors to invest in good stocks. There is a great diversity of opinion, however, on what constitutes a good stock. Some analysts favor the stocks of large corporations, such as the 30 stocks that constitute the Dow Jones Industrial Average (DJIA) or the 500 stocks that make up the Standard & Poor’s (S&P) 500 Index. Others argue the merits of small, fast-growing companies (sometimes called growth stocks), while still others believe in an approach that looks for value in stocks that are currently out of favor.

Standard & Poor’s (S&P) 500 Index

Index of large capitalization stocks.

Mutual Funds

Other analysts believe in the value of mutual funds. Mutual funds are investment companies, that is, companies that invest in stocks, bonds, and other financial instruments such as futures and options. Funds offer a number of advantages, including professional money management and portfolio diversification. Analysts who favor funds will often argue that the average individual investor is likely to do better by choosing a few good funds than by trying to manage a portfolio on his or her own. They are better off, the argument goes, choosing an outstanding mutual fund with a great track record and a really smart portfolio management team.

diversification

Investing in a broad range of securities to lower risk and/or enhance return.

Mutual funds also have their share of critics, including prominent members of the fund industry. The two most frequent criticisms are that average costs are too high and average performance is too low. One of the ways that the fund industry has responded is to offer an increasing number of index funds. These are funds designed to match the return on an index such as the Dow Jones Industrial Average or the S&P 500. Typically, the costs associated with index funds are significantly lower, while the performance is designed to closely track the index. After all, indexes are the barometers of Wall Street. Their minute-by-minute fluctuations are watched by many millions of investors all over the world, while hundreds of millions hear, watch, or read about them to learn how the market did.

Bonds

Bonds have their advocates as well. Some analysts point out that investing a portion of one’s wealth in bonds is a good way to diversify a stock portfolio, while others emphasize the security of principal and interest payments offered by bonds of high credit quality. Still others point to the tax advantages of bonds, especially municipal bonds.

On the negative side, critics believe that bonds do not offer a good return relative to stocks and that they have their own risks, including default risk, sensitivity to interest rates, currency exchange rates, and the business cycle.

ETFs

Exchange traded funds (ETFs) are similar to index-based mutual funds, however, they trade on stock exchanges and may be purchased or sold throughout the day at or close to their net asset value. Among their potential advantages are liquidity, tax efficiency, and generally lower costs. These features have made them extremely popular and among the fastest growing segments of the investment business.

On the other hand, some critics argue that ETFs encourage speculation and that the costs associated with frequent trading can be extremely high. Another potential problem is the proliferation of ETFs into so many obscure indexes and trading ideas with the result that liquidity and market cap evaporate.

Options

Options can be used in a variety of ways, ranging from portfolio risk reduction to outright speculation. Most options are short-term investments and must be monitored closely. Advocates of options for individual investors commonly point to the potential for spectacular returns through financial leverage, though sometimes they are marketed as a way of “insuring” your portfolio against a market downturn. Critics contend that the cost of trading options is frequently very high for individual investors and that most individuals who use options to speculate lose money.

Futures

Futures have many of the same uses as options, with similar potential for high returns arising from leverage. Unlike options, however, futures bear the added risk of margin calls. For this reason, futures investments must be monitored very closely. An alternative to direct investment in futures is a managed futures account, which is like a mutual fund for futures. Costs of managed futures can be much higher than those for mutual funds. Furthermore, while some managed futures have had spectacular returns for a year or more, critics contend that most managed futures accounts, particularly the ones available to the general public, are poor investments.

Summary

This chapter reviewed some frequently heard arguments, pro and con, for the six major classes of investment vehicles: stocks, mutual funds, bonds, ETFs, options, and futures. In the succeeding sections of this book, we will examine these vehicles in far greater detail.

Chapter 3

CONFRONTING INFORMATION OVERLOAD

There’s no getting around it: The financial markets are complicated and getting more so every day. The sheer range of financial products and services, accompanied by an expanding mass of marketing materials and messages, can lead to frustration about whether it is even possible to make sense of it all. While there are no easy, one-size-fits-all solutions in the world of investing, it is certainly possible to get a good understanding of how the financial markets work and how you can use them to your advantage. Reading this book is an essential start.

What makes financial markets so complicated? In a strong sense, the markets’ complexity is a mirror of the complex global economy and of the billions of individuals whose daily actions underlie both. If all investors had the exact same financial goals and timetables, financial markets might never have developed at all. It is because people view their financial goals with different time horizons, with different risk tolerances, from within different national and geographical boundaries, and with different aptitudes, tastes, and ambitions that the necessity of trading in financial instruments arises. Consider the following two examples:

1. The Lerner family is saving for a child’s college education, for which they will need money in five years. It might make sense for them to invest in, say, a U.S. government bond with a maturity of five years in order to deal with their expected future liability.

2. Meanwhile, the Transit family needs to buy a car to enable one of its members to commute to a new job. They need to sell a portion of their investments, perhaps withdrawing cash from a stock fund, in order to make a down payment on the car.

From these examples, we learn a basic principle that drives markets: Investors’ divergent financial needs create a demand for markets in financial instruments. At one time, it might make sense for one investor to buy stock, while his or her neighbor could be better served by investing in a mutual fund. At a later time, their situations might reverse. Markets allow investors to buy and sell a wide variety of financial products at prices that derive from the collective actions and judgments of market participants. Note that while each family may need the same amount of money, the time frame in which those funds are necessary is very different.

Despite individual differences in risk tolerance, time horizon, and other factors, there are many things that investors share in common. In general, it can be said that all investors seek the maximum return on their investment, subject to a variety of limitations, including investor constraints (what they are allowed to invest in), investor choices (what they want to invest in), and investor safety (what they believe to be a sufficiently safe investment).

Investor Constraints

Every investor, from the individual of limited means to the manager of a large pension fund, has constraints on what he or she can buy. Sometimes these constraints are financial, such as minimum income or net worth requirements that must be met for investing in so-called hedge funds and for trading in futures and options markets. Frequently, such financial constraints are coupled with a requirement that the investor have some prior experience in the financial markets so that he or she is not starting out with an inappropriately risky investment.

Sometimes there are legal constraints, for example when foreign investors are precluded from owning more than a certain percentage of a domestic company. Other constraints may result from the practice of socially responsible investing, which takes into account the moral values of the investor or investment policy committee, who may wish to avoid investing in a certain industry or country. On still other occasions, the constraint is determined by practical considerations, such as the need for a certain level of return (a so-called hurdle rate) or for a high degree of correlation with a benchmark.

benchmark

A standard used for valuation purposes.

Investor Choices

Despite all the talk about herd mentality, all investors do not think alike. Some investors avoid the financial markets entirely, choosing instead to invest their savings in real estate, family businesses, art, and so forth, while keeping an adequate supply of readily available cash on deposit with a federally insured bank. Others, while feeling comfortable with some combination of bonds (U.S. government, AAA-rated corporate, and tax-exempt), avoid investing in the stock market because they perceive it as too risky. Still others prefer to invest in stock only indirectly, through the purchase of top-performing equity mutual funds, perhaps within a tax-deferred IRA or 401(k) retirement plan. Finally, there are investors who take a passionate interest in finding the next great growth or story stock, or who painstakingly assemble and monitor a long-term portfolio of stocks chosen for their intrinsic value, perhaps according to some indicator, financial ratio, or quantitative model.

growth stock

Stock of a company with growing earnings and/or sales.

story stock

Stock of a new company without real earnings, but with an exciting idea, opportunity, or technology.

Behind all of these choices are the varied lessons that different people have taken from recent (and not-so-recent) economic history. Those old enough to remember the Great Depression may tend to view things through a different lens than those of us whose formative years were in the postwar boom era, the stagflation, gasoline lines, and gold boom of the 1970s, or the great stock market boom of the 1980s and 1990s. This makes good sense. It also makes markets, as investors chase different objectives with different views of value.