11

Chapter Three

PARTICIPATING IN THE MARKET

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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Measures of Price Performance: Measures of Price Performance: Market IndexesMarket Indexes

Indexes and AveragesIndexes and Averages

Dow Jones AveragesDow Jones Averages Standard & Poor IndexesStandard & Poor Indexes Value Line AverageValue Line Average Other Market IndexesOther Market Indexes

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Buying and Selling in the MarketBuying and Selling in the Market

Cash or Margin AccountCash or Margin Account Long or Short?–That Is The QuestionLong or Short?–That Is The Question

Types of OrdersTypes of Orders

Cost of TradingCost of Trading

Taxes and the 2003 Tax ActTaxes and the 2003 Tax Act Capital Gains and DividendsCapital Gains and Dividends

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MEASURES OF PRICE PERFORMANCE MEASURES OF PRICE PERFORMANCE COMPARE WITH MARKET INDEXESCOMPARE WITH MARKET INDEXESPlease click on the icon for more information on the indexesPlease click on the icon for more information on the indexes

TYPE OF PORTFOLIOTYPE OF PORTFOLIO RELEVANT INDEXRELEVANT INDEX

Professional pension fund Professional pension fund manager’s portfoliomanager’s portfolio

S&P 500 Stock Index S&P 500 Stock Index

Mutual fund specializing in Mutual fund specializing in small OTC stockssmall OTC stocks

NasdaqNasdaq

Portfolio of a small investor Portfolio of a small investor (in small cap stocks)(in small cap stocks)

Value Line Average Value Line Average or Russell 2000 or Russell 2000

www.nasdaq.com

www.standardandpoors.com

www.russell.com

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IndexIndex

Statistical Statistical indicatorindicator providing a providing a representation of the value of the representation of the value of the securitiessecurities which constitute it. Indexes which constitute it. Indexes often serve as barometers for a given often serve as barometers for a given market or industry and market or industry and benchmarksbenchmarks against which financial or economic against which financial or economic performance is measured.performance is measured.

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INDEXES AND AVERAGESINDEXES AND AVERAGES

Dow Jones AveragesDow Jones Averages• www.www.djdj.com.com

Standard & Poor’s IndexesStandard & Poor’s Indexes• www.standardpoors.comwww.standardpoors.com

Value Line AverageValue Line Average• www.valueline.comwww.valueline.com

Other Market IndexesOther Market Indexes• www.nasdaq.comwww.nasdaq.com

National Association of SecuritiesNational Association of Securities

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Dow Jones AveragesDow Jones Averages Industrial (DJIA)Industrial (DJIA) Transportation (DJTA)Transportation (DJTA) Utilities (DJUA) Utilities (DJUA)

Averages are maintained and reviewed by Averages are maintained and reviewed by editors of editors of The Wall Street JournalThe Wall Street Journal. For the . For the sake of continuity, composition changes are sake of continuity, composition changes are rare, and generally occur only after corporate rare, and generally occur only after corporate acquisitions or other dramatic shifts in a acquisitions or other dramatic shifts in a component's core business. When such an component's core business. When such an event necessitates that one component be event necessitates that one component be replaced, the entire index is reviewed. As a replaced, the entire index is reviewed. As a result, multiple component changes are often result, multiple component changes are often implemented simultaneouslyimplemented simultaneously

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Dow Jones Averages - Dow Jones Averages - continuedcontinued

There are no rules for component selection, There are no rules for component selection, a stock typically is added only if it hasa stock typically is added only if it has • an excellent reputationan excellent reputation• demonstrates sustained growthdemonstrates sustained growth• is of interest to a large number of investors is of interest to a large number of investors • accurately represents the sector(s) accurately represents the sector(s)

covered by the averagecovered by the average

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DJIA continuedDJIA continued DJTA include only transportation stocksDJTA include only transportation stocks DJUA include only utilities stocksDJUA include only utilities stocks DJIA not limited to traditionally defined industrial DJIA not limited to traditionally defined industrial

stocksstocks• Serves as a measure of the entire U.S. market, Serves as a measure of the entire U.S. market,

covering such diverse industries ascovering such diverse industries as financial servicesfinancial services technology technology retail retail entertainment entertainment consumer goodsconsumer goods

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Calculation of DJIACalculation of DJIA Unique Unique

• price weighted price weighted • NOT market capitalization weightedNOT market capitalization weighted

Component weightings affected only by changes in the stocks' Component weightings affected only by changes in the stocks' pricesprices

NOT (in contrast with other indexes‘) weightings that are affected NOT (in contrast with other indexes‘) weightings that are affected by both price changes and changes in the number of shares by both price changes and changes in the number of shares outstandingoutstanding

Initially, their values were calculated by simply adding up the Initially, their values were calculated by simply adding up the component stocks' prices and dividing by the number of component stocks' prices and dividing by the number of componentscomponents

Later, adjusting the divisor was initiated to smooth out the effects Later, adjusting the divisor was initiated to smooth out the effects of stock splits and other corporate actionsof stock splits and other corporate actions

The current divisor values are as follows: DJIA 0.13561241, DJTA The current divisor values are as follows: DJIA 0.13561241, DJTA 0.22477839, and DJUA 1.5940823 0.22477839, and DJUA 1.5940823

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DOW JONES INDUSTRIAL DOW JONES INDUSTRIAL AVERAGE - DJIAAVERAGE - DJIA

The most popular indexThe most popular index 30 large industrial companies30 large industrial companies ““blue-chip” index i.e. stocks of very high qualityblue-chip” index i.e. stocks of very high quality Price-weighted averagePrice-weighted average Follow the general trend of the marketFollow the general trend of the market Comprise more than 25% of market value of the Comprise more than 25% of market value of the

3,000 firms listed on the NYSE3,000 firms listed on the NYSE Bias toward high priced stocks Bias toward high priced stocks

www.djindexes.com

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Standard & Poor’s IndexesStandard & Poor’s Indexes

S&P 500 – a measure of broad stock S&P 500 – a measure of broad stock market activity (about 75% of the total market activity (about 75% of the total value of the 3,000 firms listed on the value of the 3,000 firms listed on the NYSENYSE

Used by:Used by:

• professional money managersprofessional money managers

• Security market researchersSecurity market researchers

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S&P 400 MidCap IndexS&P 400 MidCap Index

Composed of Composed of

• 400 middle-sized firms400 middle-sized firms Firms with market values between Firms with market values between

$1.2 billion and $9 billion versus S&P $1.2 billion and $9 billion versus S&P 500 which shows the performance of 500 which shows the performance of large firms like Microsoft – stock large firms like Microsoft – stock symbol MSFT, market value $300 symbol MSFT, market value $300 billion in January 2004billion in January 2004

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Other S&P IndexesOther S&P Indexes S&P 600 SmallCap IndexS&P 600 SmallCap Index

• Companies smaller that MidCapCompanies smaller that MidCap S&P 1500 combinesS&P 1500 combines

• S&P 500S&P 500• S&P 600 &S&P 600 &• S&P 400S&P 400

S&P 100S&P 100• 100 blue-chip stocks100 blue-chip stocks

For which CBOE has individual option For which CBOE has individual option contractscontracts

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The Complete List The Complete List 100 Stocks in NAZDAQ-100 100 Stocks in NAZDAQ-100

Please click on the following Hyperlink for the Please click on the following Hyperlink for the complete listcomplete list

NASDAQ-100NASDAQ-100 (the index itself) (the index itself)

The Index reflects Nasdaq's largest The Index reflects Nasdaq's largest growth companies across major industry growth companies across major industry groups. All index components have a groups. All index components have a minimum market capitalization of $500 minimum market capitalization of $500 million, and an average daily trading million, and an average daily trading volume of at least 100,000 shares volume of at least 100,000 shares

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The shadow of the IndexThe shadow of the Index

The Nasdaq 100 Index Tracking Stock The Nasdaq 100 Index Tracking Stock (symbol) QQQQ is an (symbol) QQQQ is an Exchange Traded FundExchange Traded Fund which allows which allows investors to essentially invest in all of investors to essentially invest in all of the stocks that make up the Nasdaq the stocks that make up the Nasdaq 100 in a single security100 in a single security

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This graph shows how closely the This graph shows how closely the shadow QQQ follows the Nasdaq shadow QQQ follows the Nasdaq

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Application ExampleApplication Example

Standard & Poor’s Indexes Standard & Poor’s Indexes • value-weighted indexesvalue-weighted indexes

each company weighted by its total each company weighted by its total market value as a percentage of the market value as a percentage of the total market value for all firmstotal market value for all firms

Example – a value-weighted index comprising of Example – a value-weighted index comprising of three firms A, B, and C the weighting is shown three firms A, B, and C the weighting is shown on the next slideon the next slide

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Application ExampleApplication ExampleValue-weighted IndexesValue-weighted Indexes

StockStock SharesShares PricePrice Total Market Total Market ValueValue

WeightingWeighting

AA 150150 $10$10 $1,500$1,500 12.0%12.0%

BB 200200 $20$20 $4,000$4,000 32.0%32.0%

CC 500500 $14$14 $7,000$7,000 56.0%56.0%

$12,500$12,500 100.0%100.0%

2020

Value Line AverageValue Line Average

1,700 companies from NYSE, AMEX, and 1,700 companies from NYSE, AMEX, and NASDAQNASDAQ

Equal-weighted indexEqual-weighted index• Weighted equallyWeighted equally• Regardless of market price or total market valueRegardless of market price or total market value

Equal-weighting more closely conforms to the Equal-weighting more closely conforms to the portfolio of individual investorsportfolio of individual investors

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Other Market IndexesOther Market IndexesNew York Stock ExchangeNew York Stock Exchange http://money.http://money.cnncnn

.com/markets/.com/markets/nysenyse//

The American Stock The American Stock Exchange Exchange

http://www.http://www.amexamex.com/.com/

Wilshire 5000 Equity IndexWilshire 5000 Equity Index http://http://www.neatideas.com/www.neatideas.com/w5000.htmw5000.htm

Russell 3000Russell 3000 Index symbol: Index symbol: $RAZ.X$RAZ.X   

Russell 2000Russell 2000 http://www.neatideas.com/rhttp://www.neatideas.com/r2000.htm2000.htm

Russell 1000Russell 1000 Index symbol: Index symbol: $RUXY$RUXY    or  or  $RUI.X$RUI.X  

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Other CountriesOther Countries

Every major country has an index that Every major country has an index that represents its stock exchange. Here are some of represents its stock exchange. Here are some of the more important indexes around the world:the more important indexes around the world:

FTSE 100FTSE 100 - United Kingdom - United Kingdom Hang Hang SengSeng - Hong Kong - Hong Kong NikkeiNikkei - Japan - Japan DAXDAX – Germany (Frankfurt – Germany (Frankfurt DAXDAX) ) TSXTSX - Canada - Canada CAC 40CAC 40 France France

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Important Consideration of looking Important Consideration of looking at an INDEXat an INDEX

How much the index has changed over a How much the index has changed over a given period of timegiven period of time• Hours (intraday)Hours (intraday)• DayDay• WeekWeek• MonthMonth• QuarterQuarter• Semi-annualSemi-annual• Year(s)Year(s)

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Bond Market IndicatorsBond Market Indicators

Not widely followed by Not widely followed by • Index or Index or • AverageAverage

Gauged byGauged by• Interest-rate movementsInterest-rate movements

Rising interest rates falling bond pricesRising interest rates falling bond prices

Falling interest rates rising bond pricesFalling interest rates rising bond prices

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Other Categories of BondsOther Categories of Bonds

Treasury SecuritiesTreasury Securities• Treasury notesTreasury notes• Treasury BillsTreasury Bills• Treasury BondsTreasury Bonds

Corporate debtCorporate debt Mortgaged-backed securitiesMortgaged-backed securities Municipal BondsMunicipal Bonds EurobondsEurobonds

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Mutual Fund AveragesMutual Fund Averages

Mutual fundsMutual funds• Preferred choice of investment for many Preferred choice of investment for many

investors in the U.S. & worldwideinvestors in the U.S. & worldwide Commitment to mutual fundsCommitment to mutual funds

• Necessity of understanding the underlyingNecessity of understanding the underlying StocksStocks BondsBonds

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Buying and Selling in the MarketBuying and Selling in the Market

Using full service brokers, e.g.Using full service brokers, e.g.• Merrill LynchMerrill Lynch• Salmon Smith BarneySalmon Smith Barney• UBS Paine WebberUBS Paine Webber

Broker must determine investors’ objectiveBroker must determine investors’ objective• Conservative – preservation of capitalConservative – preservation of capital• IncomeIncome• Growth plus incomeGrowth plus income• GrowthGrowth

Risk versus (expected) returnRisk versus (expected) return

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Buying and Selling in the Market -Buying and Selling in the Market -continuedcontinued

Using discount brokersUsing discount brokers Using online brokersUsing online brokers

• Charge very low commissionsCharge very low commissions• Give stripped-down serviceGive stripped-down service• No investment adviceNo investment advice• Communications usually by emailsCommunications usually by emails

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Cash or Margin AccountCash or Margin Account

Cash account Full paymentCash account Full payment Margin account Pay a percentage Margin account Pay a percentage Settlement in three (3) business days for Settlement in three (3) business days for

both type of accountboth type of account Margin percentage set by the Federal Margin percentage set by the Federal

Reserve BankReserve Bank• Used to control speculationUsed to control speculation• 10% in 1920s10% in 1920s• 80% in 196880% in 1968• 50% since 197450% since 1974

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Long or Short? – Long or Short? – That is the QuestionThat is the Question

ACTIONACTION OBJECTIVEOBJECTIVE POSITIONPOSITION

Buy stocksBuy stocks Profit from expected Profit from expected increase in priceincrease in price LongLong

Sell stocks Sell stocks (not owned) (not owned)

Profit from expected Profit from expected decline in pricedecline in price ShortShort

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Types of OrdersTypes of Orders

Market order – usually trade close to the last Market order – usually trade close to the last priceprice

Limit ordersLimit orders• When buying – pay NO more than the limit priceWhen buying – pay NO more than the limit price• When selling – receive no less than the When selling – receive no less than the limit pricelimit price

Stop order -Stop order - an order to buy or sell a stock an order to buy or sell a stock once the price of the stock reaches a once the price of the stock reaches a specified price, known as the stop price. specified price, known as the stop price. When the specified price is reached, the When the specified price is reached, the stop order becomes a stop order becomes a market ordermarket order

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Length of Time for Executing Length of Time for Executing Orders to Buy/Sell SecuritiesOrders to Buy/Sell Securities

Day orders – expire at the end of the dayDay orders – expire at the end of the day Good till canceled (GTC) - order to buy or Good till canceled (GTC) - order to buy or

sell a security that is good until the sell a security that is good until the investorinvestor decides to cancel it decides to cancel it

• Most Most brokeragebrokerage firms let GTC orders firms let GTC orders automatically expire after 30 - 60 daysautomatically expire after 30 - 60 days

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Cost of TradingCost of Trading

Full-service brokerageFull-service brokerage• Merrill LynchMerrill Lynch• UBS PaineWebberUBS PaineWebber• Morgan Stanley Dean WitterMorgan Stanley Dean Witter

Discount brokersDiscount brokers• Charles SchwabCharles Schwab• Quick &ReillyQuick &Reilly• OldeOlde

Online brokersOnline brokers• AmeritradeAmeritrade• E-tradeE-trade

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Effects of Pricing Differential Effects of Pricing Differential Example: 100 shares traded at Example: 100 shares traded at $40/share i.e. total of $4,000$40/share i.e. total of $4,000

Broker typeBroker type Commission/Total tradeCommission/Total trade % % commissioncommission

OnlineOnline $15/$4,000$15/$4,000 0.370.37

DiscountDiscount $42/$4,000$42/$4,000 1.051.05

Full-serviceFull-service $100/$4,000$100/$4,000 2.502.50

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Other Factors to Consider before Other Factors to Consider before Choosing the Type of Brokerage ServiceChoosing the Type of Brokerage Service

Degree of sophistication of the investorDegree of sophistication of the investor Degree of complexity of the investmentDegree of complexity of the investment

• Capital gains tax implicationsCapital gains tax implications• Potential merger offersPotential merger offers• Retirement planningRetirement planning• Estate planningEstate planning

ALL the above may outweigh savings in ALL the above may outweigh savings in commissionscommissions

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The Merits and Drawbacks of The Merits and Drawbacks of Internet & Online TradingInternet & Online Trading

ProsPros ConsCons

Availability of instant Availability of instant informationinformation

How to interpret the How to interpret the informationinformation

Downloading Downloading Balance sheetsBalance sheets Income statementIncome statement Up-to-the-minute press Up-to-the-minute press releases releases(Hint: Google search for Free (Hint: Google search for Free Edgar, requires free Edgar, requires free registrartion)registrartion)

The requirement to knowThe requirement to knowAccountingAccountingFinanceFinanceInvestmentInvestmentEconomicsEconomicsTaxTaxLegal issuesLegal issues

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Taxes and the 2003 Tax ActTaxes and the 2003 Tax Act

Legal tax advice provided only by a CPA or Legal tax advice provided only by a CPA or CFP (Certified Financial Planner)CFP (Certified Financial Planner)

Tax considerations could outweigh savings Tax considerations could outweigh savings on brokerage commissionson brokerage commissions

Please click on the following icon for a Please click on the following icon for a summary of the 2003 Tax Actsummary of the 2003 Tax Act

www.turbotax.com

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Calculating the Marginal Tax RatesCalculating the Marginal Tax RatesExample: Single - taxable income of $34,000Example: Single - taxable income of $34,000

AmountAmount Rate in %Rate in % Tax in $Tax in $

FirstFirst $7,000$7,000 10%10% $700$700

NextNext $21,400*$21,400* 15%15% $3,210$3,210

NextNext $5,600**$5,600** 25%25% $1,400$1,400

$5,310$5,310

* $28,400 – $7,000* $28,400 – $7,000

** $34,00 - $28,400** $34,00 - $28,400

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Calculating the Average TaxCalculating the Average Tax Example: Single - taxable income of $34,000Example: Single - taxable income of $34,000

Amount of taxes paidAmount of taxes paid Divided by taxable incomeDivided by taxable income

Taxes paid $5,310.10Taxes paid $5,310.10

Taxable income $34,000.00Taxable income $34,000.00

Average Tax Rate = 15.62%Average Tax Rate = 15.62%

==

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Capital Gains and DividendsCapital Gains and Dividends

Capital gain or loss Capital gain or loss • Asset held for investment purposesAsset held for investment purposes• SoldSold

Asset held for more than one yearAsset held for more than one year

Long-term capital gainLong-term capital gain

Max tax rate on dividends 15%Max tax rate on dividends 15%

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Comparing Taxes Comparing Taxes Long-term Capital Gains Long-term Capital Gains

versus versus Short-term Capital GainsShort-term Capital Gains

Holding PeriodHolding Period ProfitProfit Tax RateTax Rate TaxesTaxes

6 months6 months $10,000$10,000 35%35% $3,500$3,500

Over 12 monthsOver 12 months $10,000$10,000 15%15% $1,500$1,500

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WebsiteWebsite CommentComment

www.msci.comwww.msci.com Provides information on Provides information on bond and stock indexesbond and stock indexes

www.barra.comwww.barra.com Provides information on Provides information on various modified indexesvarious modified indexes

www.sec.govwww.sec.gov Provides access to SEC Provides access to SEC filingsfilings

www.quicken.comwww.quicken.com Provides access to Provides access to company SEC filingscompany SEC filings

finance.yahoo.com/finance.yahoo.com/ Profile pages on stock Profile pages on stock quotes provide access to quotes provide access to company SEC filingscompany SEC filings

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WebsiteWebsite CommentComment

www.standardandpoors.com www.standardandpoors.com Contains information about S&P Contains information about S&P indexes and the marketsindexes and the markets

www.dowjones.com www.dowjones.com Provides information about the Provides information about the Dow Jones indexesDow Jones indexes

www.ashkon.com/nasdaq-100.html www.ashkon.com/nasdaq-100.html Components of NASDAQ-100 Components of NASDAQ-100 (QQQ)(QQQ)

http://www.investorwords.com http://www.investorwords.com Investing glossaryInvesting glossary

http://finance.yahoo.com/etf/education/04http://finance.yahoo.com/etf/education/04 Exchange Traded FundsExchange Traded Funds

http://finance.yahoo.com/q?s=QQQQ http://finance.yahoo.com/q?s=QQQQ Quotes and InformationQuotes and Information

www.sec.govwww.sec.gov US Security and Exchange US Security and Exchange Commission’s websiteCommission’s website

www.bloomberg.comwww.bloomberg.com Market data: rates & bondsMarket data: rates & bonds