Stocks & Bonds Tidbits
You can't tell how expensive a stock is by looking only
1. Over the long term, stocks have historically
outperformed all other investments.
2. Over the short term, stocks can be hazardous
to your financial health.
3. Risky investments generally pay more than
safe ones (except when they fail)1.
4. The biggest single determiner of stock prices is
earnings.2
5. A bad year for bonds is normal stocks.
6. Rising interest rates are bad for bonds3
7. Inflation may be the biggest threat to long-
term investments.
8. U.S. Treasury bonds provide almost no risk.4
9. A diversified portfolio is less risky than a
portfolio that is concentrated in one or a few
investments.
10. Index mutual funds often outperform actively
managed funds.5
Stocks
Stocks can be divided by:
• Company size (measured by market
capitalization),
• Sector (emerging markets, technology…)
• Types of growth patterns (aggressive, income,
liquid)
 Stock prices track earnings.
Over the short term, the behavior of the market is
based on enthusiasm, fear, rumors and news. Over the
long term, though, it is mainly company earnings that
determine whether a stock's price will go up, down or
sideways.
 Stocks are your best shot for getting a return
over and above the pace of inflation.
The average large stock has returned more than 10
percent a year -- well ahead of inflation, and the return
of bonds, real estate and other savings vehicles.
 Individual stocks are not the market.
A great track record does not guarantee strong
performance in the future. Stock prices are based on
projections of future earnings. A strong track record
bodes well,
1
Investors demand a higher rate of return for taking greater
risks. That's one reason that stocks, which are perceived as
riskier than bonds, tend to return more.
2
Over the short term, stock prices fluctuate based on
everything from interest rates to investor sentiment to the
weather. But over the long term, what matters are earnings.
3
Because bond buyers won't pay as much for an existing
bond with a fixed interest rate of, say, 5 percent because they
know that the fixed interest on a new bond will pay more
because rates in general have gone up.
4 A broker may sell you a bond that is paying a "coupon"
U.S. Government is unlikely ever to default on its bonds --
partly because the American economy has historically been
fairly strong and partly because the government can always
print more money to pay them off if need be.
5
Few actively managed funds can consistently outperform the
market by enough to cover the cost of their generally higher
expenses.
at its price.
Because a stock's value is depends on earnings, a
$100 stock can be cheap if the company's earnings
prospects are high enough, while a $2 stock can be
expensive if earnings potential is dim
Assessing value of a stock
To get a sense of whether a stock is over- or
undervalued, investors compare its price to revenue,
earnings, cash flow, and other fundamental criteria.
Comparing a company's performance expectations to
those of its industry is also common -- firms operating
in slow-growth industries are judged differently than
those whose sectors are more robust.
As a general rule, it's best to hold stocks from
several different industries. That way, if one area of
the economy goes into the dumps, you have
something to fall back on.
It's smarter to buy and hold good stocks than to
engage in rapid-fire trading.
The cost of trading has dropped; commissions are
cheaper.
Other costs to trading:
• Mark-ups by brokers
• Higher taxes for short-term trades
• active trading requires paying close, up-to-the-
minute attention to stock-price fluctuations
Bond Tips
Bonds are NOT turbo-charged CDs. Though their life
span and interest payments are fixed -- thus the term
"fixed-income" investments -- their returns are not.
Bond prices move in the opposite direction of
interest rates.
When interest rates fall, bond prices rise, and vice
versa. But if you hold a bond to maturity, price
fluctuations don't matter.
With a bond, you always get your interest and principal
at maturity, assuming the issuer doesn't go belly up.
With a bond fund, your return is uncertain because the
fund's value fluctuates.
Inflation erodes the value of bonds' fixed interest
payments. Stock returns, by contrast, stand a better
chance of outpacing inflation.
Consider tax-free bonds.
Tax-exempt municipal bonds yield less than taxable
bonds, but they can still be the better choice for
taxable accounts. That's because tax-free bonds
sometimes net you more income than you'd get from
taxable bonds after the taxes are taken out.
Pay attention to total return, not just yield.
-- or interest rate -- of 6 percent. If interest rates rise,
however, then the price of the bond will fall. If the price
drops by 2 percent, its total return for the first year -- 6
percent in income less a 2 percent capital loss -- would
be only 4 percent.
If you want capital gains, go long.
When interest rates are high, gamblers who want to
bet that they'll head lower should buy long-term bonds
or bond funds, especially "zeros." Reason: when rates
fall, prices rise; and longer-term bonds gain more in
price than shorter-term bonds.
If you want steady income, stick with short to medium
terms.
Investors looking for income should invest in a
laddered portfolio of short- and intermediate-term
bonds.
Mutual Funds
 Performance:
 Long-Term Performance (past 2 years)
 Performance Consistency (year to year)
 Performance comparison (check similar funds)
 Risk:
 Standard deviation, the broader the range,
the higher risk
 Portfolio Mix (bonds & stocks)
 Portfolio Breakdown (what is the fund
investing in?)
 Expenses:
 Loads (expenses to buy shares; commissions)
 Fund Expenses (day-to-day running the
fund; admin and salaries of fund employees)
Index Funds
An index fund or index tracker is a collective
investment scheme that aims to replicate the
movements of an index of a specific financial
market
Economists cite the efficient market theory as the
fundamental premise that justifies the creation of
the index funds.
Advantages:
Low costs - Because the composition of a target
index is a known quantity, it costs less to run an
index fund.
 Simplicity - Once an investor knows the
target index of an index fund, what securities the
index fund will hold can be determined directly
 Low Turnovers - refers to the selling and
buying securities by the fund manager
Disadvantages:
Since index funds achieve market returns, there
is no chance of out-performing the market. On
the other hand, it should not under-perform the
market significantly.
Capital Gains
If a mutual fund sells a security for a gain, the
capital gain is taxable for that year; similarly a
realized capital loss can offset any other realized
capital gains.
What is value investing?
Generally buy companies whose shares appear
underpriced by some forms of fundamental
analysis; these may include shares that are
trading at, for example, high dividend yields or
low price-to-earning or price-to-book ratios.
The essence of value investing is buying stocks at
less than their intrinsic value
"finding an outstanding company at a sensible
price" rather than generic companies at a bargain
price."
Strategies:
 Buying low PE ratio stocks
 Low price-to-cash-flow ratio stocks
 Low price-to-book ratio stocks
Time Value of Money
premise of time value of money is that an
investor prefers to receive money today, rather
than the same amount in the future, all else
being equal.
4 variables involved in TVM
 Time period
 # of payments6
 interest rate
 Basis (value)
 Present Value - How much you got now.
:: what is the value now of a zero-coupon
bond that will pay $1,000 in 10 years?
 Future Value - How much what you got now
grows to when compounded at a given rate
:: how much will be in my savings account
at year end, which has $1,000 in it now, and
pays 5% compounded yearly?
 Present Value of an Annuity (PVA) is the
present value of a stream of future payments. It
determines the value of your mortgage today,
:: Can I afford 20 years of payments of
$xxx?
 Future Value of an Annuity (FVA) is the
future value of a stream of payments (annuity).
6
Payments are a series of equal, evenly-spaced
cash flows.
:: If I save $2,000 per year and it earns 5%
compounded yearly, what will be the total
sum after 40 years?
“concept that a dollar that you have today is
worth more than the promise or expectation that
you will receive a dollar in the future.”
:: INTEREST (SIMPLE VS. COMPOUND)
 Simple interest is computed only on the
original amount borrowed. It is the return on
that principal for one time period.
 Compound interest is calculated each
period on the original amount borrowed plus
all unpaid interest accumulated to date
Interest Rates
 APR refers to the annual percentage rate of
interest you are charged on your credit card.
It's the same thing as your interest rate.
 The Prime Rate is used by banks to set the
benchmark interest rate for their loans.
 Fixed Rate or fixed APR refers to an interest
rate that will not change until the issuer
decides to change it.
 A variable rate is tied to a certain index
(such as the prime rate, T-Bills, LIBOR, etc.),
and, as the name implies, varies depending
on what direction the index goes.
> Load Amortization
A method for repaying a loan in equal
installments. Part of each payment goes toward
interest and any remainder is used to reduce the
principal; As the balance of the loan is gradually
reduced, a progressively larger portion of each
payment goes toward reducing principal.
> Negative Amortization
Negative amortization occurs when the payment
is not large enough to cover the interest due for a
period.
> What is an annuity?
annuity is used in finance theory to refer to any
terminating stream of fixed payments over a
specified period of time.
> What is a perpetuity?
Perpetuity is an annuity that has no definite end.
The strike price, or exercise price, is a key
variable in a derivatives contract between two
parties.
Find the Intrinsic Value
The actual value of a security, as opposed to its
market price or book value.
 Market capitalization is the price (i.e. what
investors are willing to pay for the company)
 Intrinsic value is the value (i.e. what the
company is really worth).
Fundamental analysis - as opposed to Technical
analysis - to determine the intrinsic value of a
company.
For equities:
The "intrinsic" characteristic is the cash flow
production of the company in question. Intrinsic
value is therefore defined to be the present value
of all future net cash flows to the company.
Fundamental Analysis
involves analyzing its financial statements and
health, its management and competitive
advantages, and its competitors and markets
 Determined growth rates (of income and
cash)
 Determine risk levels (to determine the
discount rate)
Discounted cash flow model, which calculates the
present value of the future:
 dividends received by the investor, along
with the eventual sale price. (Gordon model)
 earnings of the company, or
 cash flows of the company.
Options
A contract giving an investor a right to buy
(call) or sell (put) a fixed amount of shares
(usually 100 shares) of a given stock (or indexes
and commodities) at a specified price within a
limited time period (usually three, six, or nine
months).
The purchaser hopes that the stock's price will go up 
(if he bought a call)
or
down (if he bought a put) by an amount sufficient to provide
a profit when he sells the option.
 Calls & Puts
A call gives the holder the right to buy an asset at
a certain price within a specific period of time.
Calls are similar to having a long position on a
stock. Buyers of calls hope that the stock will
increase substantially before the option expires.
A put gives the holder the right to sell an asset at
a certain price within a specific period of time.
Puts are very similar to having a short position on
a stock. Buyers of puts hope that the price of the
stock will fall before the option expires.
Participants in the Options Market
There are four types of participants in options
markets depending on the position they take:
1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts
Hedging & Speculation
a hedge is an investment that is taken out
specifically to reduce or cancel out the risk in
another investment
To understand hedging is to think of it as
insurance. insuring themselves against a
negative event7.
“Reduce their exposure to various risks”
Technically, to hedge you would invest in two
securities with negative correlations
Hedging uses financial instruments known as
derivatives8, the two most common of which are
options and futures.
Futures contracts and forward contracts are
a means of hedging against the risk of adverse
market movements
7
This doesn't prevent a negative event from happening, but if
it does happen and you're properly hedged, the impact of the
event is reduced
8
Keep in mind that because there are so many different types
of options and futures contracts an investor can hedge
against nearly anything, whether a stock, commodity price,
interest rate, or currency.
 futures contract is a standardized contract,
traded on a futures exchange, to buy or sell a
certain underlying instrument at a certain date in
the future, at a specified price.
 forward contract is an agreement between
two parties to buy or sell an asset (which can be
of any kind) at a pre-agreed future point in time.
Arbitrage
Arbitrage is the practice of taking advantage of a price
differential between two or more markets: a
combination of matching deals are struck that
capitalize upon the imbalance, the profit being the
difference between the market prices
What is volatility?
The traditional measure of risk is volatility, that is, the
annualized standard deviation of returns.
A measure of the dispersion of a set of data from its
mean. The more spread apart the data is, the higher
the deviation.
 HEDGE FUND
A hedge fund is a lightly regulated private investment
fund;hedge funds do not suffer such regulatory
restrictions; Mutual Funds may be limited to being
"long" the market by buying instruments such as
bonds, equities or money market instruments
 PRIVATE EQUITY
Private equity funds invest primarily in very illiquid
assets such as early-stage companies and so investors
are "locked in" for the entire term of the fund. Also
lightly regulated
Private Equity Investment & Private Equity Funds
Categories of private equity investment include
leveraged buyout, venture capital, growth capital,
angel investing,
not listed on a public stock exchange; "exit" or "selling
out" is often done by the way of an IPO, capitalizing the
value of the security on a stock exchange.
Private equity funds are generally organized as limited
partnerships which are controlled by the private equity
firm that acts as the general partner.
Fund obtains capital commitments from certain
qualified investors such as pension funds, financial
institutions and wealthy individuals to invest a
specified amount.
 RETIREMENT FUNDS
IRA
 Tax Deferral – Post tax; pay taxes on money you
withdraw
 Mandatory withdrawal
 Money grows tax free; only withdrawals are taxed

Roth IRAs
 Pre-taxed; No Tax deduction for deposits
 Tax-Free Withdrawals
 Early withdrawal penalties

Advantages
 Tax free growth
 Tax free withdrawal
 No mandatory withdrawal (wait as long as you can
want)

Underwriting

Banking Underwriting: underwriting is the

detailed credit analysis preceding the granting of
a loan, based on credit information furnished by
the borrower, such as employment history,
salary, and financial statements

Securities Underwriting: underwrite the

transaction, which means they have taken on the
risk of distributing the securities. Should they not
be able to find enough investors, then they end
up holding some securities themselves

Insurance Underwriting: insurance

underwriters calculate how risky it is to insure
people and businesses. They also decide how
much coverage they should receive and how
much they should pay for it.