Investments: Analysis and Behavior

1. Investments: Analysis and Behavior Chapter 3- Buying and Selling Equities

2. Learning Objectives • Know the costs of trading securities. • Be able to place a buy or sell order. • Be able to compute margin debt and returns for long and short positions. • Implement a dollar cost average strategy. • Compute the impact of taxes on investment returns. • Examine the Initial Public Offer market.

3. Buying and Selling Stocks • Stock Price Quotes • Bid is the highest price a market maker is willing to pay (and is lower than the ask). • Ask is the lowest price a market maker is willing to accept to sell. • Bid-Ask Spread is the gap between the ask and the bid quotes. • Profit goes to the market maker • Market depth • How many people are buying and selling? How much can I buy or sell without moving the price? • Bid size: the number of shares offered at the bid price • Ask size: the number of shares offered at the ask price

4. Quote from dealer market VWAP = Volume Weighted Average Price = The ratio of the value traded to total volume traded over a particular time horizon (usually one day). It is a measure of the average price a stock traded at over the trading horizon.

5. Quote from specialist market VWAP = Volume Weighted Average Price = The ratio of the value traded to total volume traded over a particular time horizon (usually one day). It is a measure of the average price a stock traded at over the trading horizon.

6. Buy now, or wait for a better price? • Market order (executed immediately) • Buy (or sell) now at market price • “Buy 50 shares of Home Depot at market” • “Sell 100 shares of Apple Computer at market” • Limit order (may take awhile to execute, or never) • Buy when the price gets a little better • How long to wait? • “Sell 100 shares of IBM at $82.70 or better, today” • “Buy 200 shares of Dell at $30.72 or better, fill or kill” • When would these trades execute? • See pages 62-64 for specific orders

7. Place an order to trade when certain price levels are reached (before the emotions set in!) • Stop order • Placing an order to sell a stock after the price has risen to a specified price. • Stop-loss order • Placing an order to sell when a stock falls to a specific price.

8. Pitfalls to Trading • Active trading (day trading) • Induces the same emotions as casinos try to elicit. • Investment decisions are more likely to be influenced by emotions and psychological biases. • The allure of active trading is strong. • People who believe they have superior information or skill feel like they should benefit by trading • Trading costs are important! (commissions and bid-ask spread (the amount by which the ask price exceeds the bid))

9. Illusions • Illusion of Knowledge • The illusion that more information creates more knowledge and better predictions • Does telling you what the last five rolls of a dice help you predict what the next roll will be? • The internet is full of information • How much is true? • Can you turn this info into wisdom? • Illusion of Control • People often believe that they have influence over the outcome of uncontrollable events. • People seem to believe that they have greater odds of winning the lottery with their own numbers than randomly picked numbers. • These illusions may cause investors to trade too much and eventually experience lower returns!

10. Impact on Return • A study of 1,607 investors which moved from discount broker to online broker. • Before going online: • average turnover was 70% • beat the market by 2.4% per year • After going online: • turnover jumped to 120% • under performed the market by 3.5% per year Brad Barber and Terrance Odean, 2002, “Online Investors: Do the Slow Die First?” Review of Financial Studies, 15, 455-487.

11. Buying Stocks Using Debt • Cash account • Most investors use a cash account. They fund the account with cash and then use the cash to buy stocks. • Margin account • You can borrow money from the brokerage firm to buy more stock. • You must start with no less than 50% of the position as your equity (called initial margin). • If the stock price falls, it is your equity that is declining • If your margin falls below the minimum maintenance margin level you will be forced to sell or add more cash.

12. Computing your equity in a margin position • Consider that you borrowed $10,000 to buy $20,000 of stock. • If the value of the stock increases to $25,000, what is your margin? • If the value of the stock declines to $15,000, what is your margin?

13. Profiting From Falling Stock Prices • The simple rule of “buy low, sell high” works well when prices are increasing. • When prices are falling, can you “sell high, buy low?” • Selling short (or short selling) • By executing a short sale, the investor sells stock that they do not own (by borrowing it from the brokerage). • Later, after the price falls (hopefully!) the stock is repurchased (called covering the short) and return to the broker. *** You borrow  You sell  You buy back

14. Short Example • Short 100 shares at $60 • Total proceeds: $60 × 100 = $6,000 • What is the equity margin and return if the price rises to $66? • Loss = ($60 - $66) × 100 = -$600

15. Short Example • What is the return if the price falls to $50? • Profit = ($60 - $50) × 100 = $1,000 • P = $75 • P = $46 • P = $20 • P = $100

16. Dollar-Cost Averaging

17. Impact of Taxes • Capital Gains • Only realized gains are taxed • Short-term (less than one year) • taxed at marginal income tax rate • Long-term (over one year) • Taxed at 20% • Dividends • Taxed at 15% • Interest Income • Taxed at marginal income tax rate Marginal Tax Rate = change in tax liability / change in taxable income = the tax rate that applies to the last dollar of the tax base (taxable income or spending)

18. The tax man cometh

19. Investing and Taxes • Tax rules change over time! • Tax deferred investing • IRA, 401(k) plans • Defers the taxes until the money is withdrawn in retirement. • Roth IRA • Pay the tax now, but no taxes in retirement. • With constant tax rates IRAs and Roth IRAs are equivalent tax shelters.

20. IRAs 2010 Combined Traditional and Roth IRA Contribution Limits • If you are under 50 years of age at the end of 2010: The maximum contribution that you can make to a traditional or Roth IRA is the smaller of $5,000 or the amount of your taxable compensation for 2010. This limit can be split between a traditional and a Roth IRA but the combined limit is $5,000. The maximum contribution to a Roth IRA and the maximum deductible contribution to a traditional IRA may be reduced depending upon your modified adjusted gross income (modified AGI). • If you are 50 years of age or older before 2011: The maximum contribution that can be made to a traditional or Roth IRA is the smaller of $6,000 or the amount of your taxable compensation for 2010. This limit can be split between a traditional and a Roth IRA but the combined limit is $6,000. The maximum contribution to a Roth IRA and the maximum deductible contribution to a traditional IRA may be reduced depending upon your modified AGI. http://www.irs.gov/retirement/participant/article/0,,id=188232,00.html

21. Issuing New Securities • New securities are issued with the help of investment banks (or underwriter) • New issues are sold on the primary market first, and subsequently sell on the secondary market. • The secondary markets are the security exchanges. • The selling of shares for the first time in a new company is called a initial public offering (IPO)

23. Who gets IPO shares? • Hot Issue Market • During some robust markets, over 50 news firms go public every month. • Many investors want these shares. • Initial returns can be high. • Cold market • During other periods, less than 10 IPOs are issued in a month. • Who gets shares? • Those who want shares ask their broker. • When more shares are sought than are being issued priority tends to go to the broker’s best clients. • If you are a small-money investor and receive shares of an IPO, look out, it may be a lemon!