An Introduction to Investments and the Investment Process

1
An Introduction to Investments and the Investment
Process

• Presented to BAP on
• April 10, 2008

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Types of Investments

• Savings Accounts
• Money Market Funds
• Mutual Funds
• Stocks
• Bonds
• Options
• Commodities
• Derivatives

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Savings Account/CDs

• Most basic of accounts
• Can be obtained at any bank
• Higher rates are available online
• Examples
• ING Direct ingdirect.com
• HSBC - us.hsbc.com/internetbanking
• GMAC Bank - gmacbank.com

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Money Market Funds

• Often touted as the safest kind of mutual fund,
  but that depends on your perspective. On the one
  hand, it's almost impossible to lose your
  principal in one of these things.
• The advantage of a money fund is that it is
  completely liquid

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Mutual Funds

• A mutual fund, according to the Securities and
  Exchange Commission (SEC), is a company that
  brings together money from many people and
  invests it in stocks, bonds or other assets.
• A mutual fund is like a basket, and that basket
  holds assets, like stocks.
• When you buy a mutual fund, you purchase a piece
  of the fund, or basket. You do not actually own
  any of the assets the mutual fund owns.

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Mutual Funds

• Advantages
• Diversification and
• Liquidity
• Professional management
• Disadvantages
• Return is not guarantee
• High cost
• False, misleading advertisement

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Mutual Funds

• Many Types
• Equity
• Bonds
• Commodities
• Foreign
• Exchange traded or ETFs
• Asset Allocation
• Index

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Mutual Funds

• Equity Funds
• Mutual funds are often categorized by the market
  capitalization of the stocks that they hold in
  their portfolios. One guideline
• Small-cap stocks
• Mid-cap stocks 500 million to 5 billion
• Large-cap stocks 5 billion
• Growth Funds
• These funds tend to look for the fastest-growing
  companies on the market.

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Mutual Funds

• Value FundsThese funds like to invest in
  companies that the market has overlooked or
  priced low relative to their earnings potential.
• Exchange-Traded Funds, or ETFs, are index funds
  that trade just like stocks on major stock
  exchanges.

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Mutual Funds

• Sector Funds
• They restrict investments to a particular segment
  -- or sector -- of the economy
• Examples
• Gold
• Technology
• Energy

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Mutual Funds

• Municipal Bond FundsInvest in bonds issued by
  state municipalities.
• High-Yield Bond FundsBond funds invest in
  different grades of corporate bonds. High-yield,
  or "junk-bond," funds are the most well-known of
  the bunch, because they offer the highest rates.
  Unfortunately, since these funds invest in
  low-grade corporate issues, they also entail the
  greatest risk.

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Mutual Funds

• Load or No-load
• No-load
• Pays no commissions
• Load
• Pays a sales charge either at the front/purchase
  or back/redemption
• Front end cannot be higher than 8.5
• Other charges
• 12b1-fee - annual distribution fees, which are
  used to pay for promotional costs. These costs
  vary from 0.25 to 0.75 percent of annual asset
  value.
• Management fee paid to the fund sponsor

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Mutual Funds

• Two categories closed-end and open-end.
• Closed-end funds have a limited number of shares.
  If you want to purchase a piece of the fund, you
  have to purchase an existing share.
• Open-end funds have an unlimited number of
  shares. If you want to purchase a piece of the
  fund, the fund creates a new share and sells it
  to you. There are significantly more open-end
  funds than there are closed-end funds.

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Mutual Funds

• Ratings
• Morningstar rates funds using a star
  systemwith 5 stars being the highest rating and
  1 star being the lowest rating.
• 5 stars indicates the fund is in the top 10
  percent of its Morningstar category.
• 4 stars indicates the fund is in the next 22.5
  percent of its category.
• 3 stars indicates the fund is in the next 35
  percent of its category.
• 2 stars indicates the fund is in the next 22.5
  percent of its category.
• 1 stars indicates the fund is in the last 10
  percent of its category.

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Mutual Funds

• Mutual funds only trade at the end of the day
  because you trade mutual funds based on their net
  asset value (NAV).
• To determine the NAV at the end of the trading
  day, the mutual fund company looks at all of the
  assets that are in the basket, determines their
  value and divides that number by the total number
  of outstanding shares in the fund.
• The fund company does it once a day once the
  market closes.

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Stocks

• Common
• General rule invest in a company whose products
  you use e.g., Starbucks
• If you work for a public company, buy its shares
• Preferred
• Dividends vs no dividends

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Bonds

• Corporate
• Investment Grade
• High yield or Junk
• Municipal
• General Obligation
• Revenue
• Treasury
• Bill
• Notes
• Bonds

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Bonds

• Advantages
• A Safe Haven For Your Money
• Slow and Steady - Predictable Returns

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Options

• A security that represents the right, but not the
  obligation, to buy or sell a specified amount of
  an underlying security (stock, bond, futures
  contract, etc.) at a specified price within a
  specified time.

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Options

• Terms
• Call OptionAn option contract which gives the
  holder the right, but not the obligation, to buy
  a specified amount of an underlying security at a
  specified price within a specified time in
  exchange for a paying a premium.
• Call PremiumThe amount a call option costs.
• Option HolderThe buyer of either a call or put
  option.
• Put OptionAn option contract giving the owner
  the right, but not the obligation, to sell a
  specified amount of an underlying security at a
  specified price within a specified time. The put
  option buyer hopes the price of the shares will
  drop by a specific date while the put option
  seller (or writer) hopes that the price of the
  shares will rise, remain stable, or drop by an
  amount less than their profit on the premium by
  the specified date.

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Options

• Terms
• In-the-Money - if you were to exercise an option
  and it would general a profit at the time, it is
  known to be in the money.
• Naked Option - An option written (sold) without
  an underlying hedge position.

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Commodities

• Commodities are the actual physical goods like
  Grains (corn, soybeans, wheat), Metals (gold,
  silver, copper) Energy (crude oil, gasoline,
  heating oil), Softs (coffee, sugar, cotton),
  Livestock (cattle, hog)
• Futures are contracts of commodities that are
  traded at a futures exchange like the Chicago
  Board of Trade (CBOT).
• Futures contracts have expanded beyond just
  commodities now there are futures contracts on
  financial markets like the SP 500, t-notes,
  currencies and many others.

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Commodities

• Example - Crude Oil Fundamentals
• Light Sweet Crude Oil is traded on the New York
  Mercantile Exchange (NYMEX). "Light Sweet" is the
  most popular grade of crude oil that is traded.
  Another grade of oil is Brent Crude, which is
  primarily traded in London.
• Crude oil is the raw material that is refined to
  produce gasoline, heating oil, diesel, jet fuel
  and many other petrochemicals.
• When crude oil is refined, or processed, it takes
  about 3 barrels of oil to produce 2 barrels of
  unleaded gas and 1 barrel of heating oil.

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Derivatives

• Are financial instruments whose value changes in
  response to the changes in underlying variables.
  The main types of derivatives are futures,
  forwards, options, swaps.
• The main use of derivatives is to reduce risk for
  one party

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Derivatives

• Speculation
• Derivatives traders may also look for arbitrage
  opportunities between different derivatives on
  identical or closely related underlying
  securities
• Fair value hedging
• Hedge of an exposure to changes in the fair value
  of an asset, liability etc. that is attributable
  to a particular risk e.g., oil prices

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Derivatives - How do Futures Work?

• Futures are standardized contracts among buyers
  and sellers of commodities that specify the
  amount of a commodity, grade / quality and
  delivery location. Commodity trading with futures
  contracts takes place at a futures exchange and,
  like the stock market, is entirely anonymous.
• For example the buyer might be an end-user like
  Kelloggs. They need to buy corn to make cereal.
  The seller would most likely be a farmer, who
  needs to sell his corn crop. They create a
  contract of December Corn futures at the current
  market price. A contract of corn at the CBOT
  consists of 5,000 bushels. Therefore, the farmer
  would have to deliver 5,000 bushels of corn to
  Kelloggs in December at a designated location.

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Investing

• Tax Deferred
• 401k Plan
• IRA
• Taxable
• Brokerage Account
• Traditional (or full service) Merrill Lynch
• expensive
• Online(discount, self managed) Etrade,
  Scottrade, BofA
• cheap

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Type of Margin

• Cash AccountAn account in which the customer is
  required to pay in full for all purchased
  securities.
• Margin AccountA customer account in which a
  brokerage firm lends the customer part of the
  purchase price of a trade.
• Margin CallA call from a broker signaling the
  need for a trader to deposit additional money
  into a margin account to maintain a trade.

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Major Exchanges

• NYSE Euronext (NYX)
• operates the worlds leading and most liquid
  exchange group
• family of exchanges, located in six countries,
  include the New York Stock Exchange (the world's
  largest cash equities market) Euronext, (the
  Eurozone's largest cash equities market) Liffe,
  Europe's leading derivatives exchange by value of
  trading and NYSE Arca Options, one of the
  fastest growing U.S. options trading platforms.
• NASDAQ
• National Association of Securities Dealers
  Automated Quotations system -- a computerized
  system providing brokers and dealers with price
  quotations for securities traded over-the-counter
  as well as for many New York Stock Exchange
  listed securities.

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Major Exchanges

• The New York Mercantile Exchange, Inc. (MERC)
• is the world's largest physical commodity futures
  exchange and the preeminent trading forum for
  energy and precious metals.
• Chicago Board Options Exchange (CBOE)
• The largest options exchange in the United
  States.
• Chicago Board of Trade (CBOT)
• Established in 1886, the CBOT is the oldest
  commodity exchange in the United States and
  primarily lists grains, T-Bonds and notes, metals
  and indexes.
• - part of the CME Group. In the process of
  merging with the Merc

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DJIA

• Dow Jones Industrial Average (DJIA)Used as an
  overall indicator of market performance, this
  average is composed of 30 blue chip stocks which
  are traded daily on the New York Stock Exchange.

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Resources

• Important to educate yourself
• NASDAQ
• Morningstar
• Kiplinger
• Yahoo Finance
• CNBC