The introduction for stocks provides basic terms and concepts about the stock market in general.
Equity security is the formal term for stock in a publicly traded company. When you hear the word "equity" it means ownership, which is what a share of stock represents. Similarly, bonds are always equated with the word "debt." The word "security" references either stocks or bonds. It is defined as the evidence of ownership in the case of stocks, and evidence of debt in the case of bonds. Thus, stocks are an equity security while bonds are a debt security.
There are three types of stocks: common, preferred, or convertible. As the name says, common stock is the most common type of equity security. The term common stock is used for any equity security that has no special dividend rights and has the lowest priority claim in the event of bankruptcy. Owners of preferred stock, in contrast, usually receive preferred treatment when it comes to receiving dividends of cash payoffs in bankruptcy. There are also convertible securities that start as one type but can be converted into another if the investor desires. Most convertible securities are preferred stock or bonds that are convertible into common stock.
Common stock represents a basic ownership claim in a corporation. Think of this as the investors who have put up investment capital to get things going, just like if you decided to invest in the creation of a business in the town or city that you live. Whoever starts the company can sell partial ownership of it in order to capitalize, or raise money for company growth.
The most important thing about common stock is that it represents a residual claim against the corporation's cash flows or assets. In other words, if the company goes bankrupt, shareholders have a legal right to repayment in bankruptcy court. However, common stockholders are last in line. All prior debts must be paid to the employees (wages), the government (taxes or judgments), short term creditors (banks), bondholders (long term lenders), and preferred shareholders (owners). The common stockholders get whatever is left, the residual value of the firm. Therefore, the value of common stock is directly related to the company's profits.
Legally, common stockholders enjoy limited liability, meaning that their losses are limited to the original amount of their investment when they bought their common stock. For example, the Bhopal Disaster of 1984 is considered to be the worst industrial disaster in history. It was caused by the accidental release of 40 tons of methyl isocyanate (MIC) from Union Carbide India Limited, a pesticide plant located in the heart of the city of Bhopal, India. The accident, in the early hours of December 3, 1984, produced heavier-than-air toxic MIC gas which rolled along the ground through the surrounding streets killing thousands outright. The gas also injured anywhere from 150,000 to 600,000 people, of whom at least 15,000 later died. Heads rolled at the corporate level in the aftermath, but none of the common or preferred shareholders stood to lose more than the initial investment they made when they purchased the company stock.
A dividend is a portion of a company's profits that is paid to its stockholders. Common stock dividends are not guaranteed, and are often irregular or even non-existent. Dividends are always paid from the company's after-tax cash flows. Because dividend income is taxable for most investors, dividends are double taxed – once when the company pays the corporate income tax on its profits, and once more when the investors pay their personal income taxes. To avoid double taxation, some investors hold stocks in growth companies that reinvest their accumulated earnings instead of paying large cash dividends.
Companies will sometimes reinvest their accumulated earnings back into the business instead of paying out dividends. This allows the company to accumulate capital and grow faster than it otherwise might. As a firm's earnings grow, people expect its stock price to rise. If this happens, the stockholders can sell their stock and pay capital gains taxes on their profits. The Tax Reduction Act of 1997 set a lower tax rate on capital gains than on dividends. Taxes on capital gains are paid only upon the realization of the gain, meaning when it is sold. Investors can reduce their tax bills by delaying the sale of securities to postpone realization of capital gains.
Even though stockholders hold ownership of the corporation, they do not exercise control over the firm's day-to-day activities of doing business. They do, however, exercise control over the firm's operations indirectly by electing the board of directors. It is the task of the board of directors to monitor the management's activities on behalf of the shareholders. As a practical matter, most shareholders cannot actually vote in person, but instead by proxy where they vote by absentee ballot or endorse a representative.
Like common stock, preferred stock represents ownership in a corporation. As the name implies, it receives preferential treatment over the common stock with respect to dividend payments and their claim to the firm's assets in the event of a bankruptcy. Preferred stockholders are entitled to the issue price of their stock plus the dividends they are owed. This is, of course, after the bondholders have been paid.
A preferred stock's dividend is a payment made by the firm at regular intervals, similar to the interest payments on a bond. Most preferred stock is nonparticipating and cumulative. Preferred stock is nonparticipating in the sense that the preferred dividend remains constant regardless of any increase in the firm's earnings.
Firms can decide, however, not to pay the dividends on preferred stock right away. They will be paid in a later period, and are called dividends in arrears. The cumulative feature of preferred stock means that the company always owes these dividends to the preferred stockholders, and they accumulate over time. The firm must pay preferred dividends in arrears before a dividend on its common stock can be paid.
Some preferred stock is issued with adjustable dividends. Adjustable-rate preferred stock became popular in the early 1980s when interest rates were rapidly changing. The dividends of adjustable-rate preferred stocks adjust periodically to changing market interest rates.
Preferred stockholders do not have voting rights. Exceptions to this rule can occur when the corporation is in arrears on its preferred dividend payments, but this is rare.
Convertible preferred stock can be converted to common stock at a predetermined ratio (such as two shares of common stock for each share of preferred stock). If the common stock rises in price, the holder can choose to convert the preferred shares into common shares. After conversion, preferred dividend payments are no longer received.
Convertible bonds are bonds that can be exchanged for shares of common stock. Before conversion it is corporate debt, thus the bond interest and principal payments are contractual obligations of the corporation. Most convertible bonds are subordinated debentures, meaning that they get paid after other bonds are paid, so investors who own convertible bonds have lower ranking claim against corporate profits than most other debt holders.
New issues of securities are called primary offerings. Stock purchases through primary offerings are called primary market transactions. The company uses the funds raised by the sale of securities in primary offerings to expand production, enter new markets, further research, or enhance other aspects of the firm's operations. After this, whenever the securities are bought or sold it is in the secondary market.
If the company has never before offered a particular type of security to the public it is called an unseasoned offering or initial public offering (IPO). If they issue additional securities that are similar to those trading in the secondary market, it is known as a seasoned offering. For example, Wal-Mart "went public" in 1978 when it made its first IPO of common stock that immediately started trading on the New York Stock Exchange under the ticker symbol "WMT." This was an unseasoned offering at the time. When WMT issued more shares of the same common stock it was called a seasoned offering because it was just more of the same stock being released into the market.
A ticker symbol, also simply called a symbol, is a system of letters used to uniquely identify a stock or mutual fund. Symbols with up to three letters are used for stocks which are listed and traded on an exchange. Symbols with four letters are used for most Nasdaq stocks. Symbols with five letters are used for Nasdaq stocks with multiple issues of common stock. Symbols with five letters ending in X are used for mutual funds.
Companies raise money quickly when the stock prices rise because they can sell seasoned offerings to the public at a price higher than the unseasoned offering. They don't have to pay interest to bondholders or loan payments to banks when they raise money this way. Alternatively, as the company's stock drops, it becomes more expensive for the company to capitalize with equity and they have to use more debt, either bonds or bank financing. New issues of equity securities may be sold directly to investors by the issuing corporation, but are usually distributed by an investment banker in an underwritten offering, a private placement, a rights offering, or a shelf registration.
The most common distribution method is an underwritten offering in which the investment banker purchases the securities from the firm at a guaranteed amount and then resells the equity securities to public investors for a greater amount. The difference is called the underwriter's spread, which compensates the investment banker for the expenses and risks involved in the offering.
Also, some equity securities are distributed through private placements in which the investment banker acts only as the company's agent and receives a commission for placing equity securities with investors.
A company will occasionally place equity securities with its existing shareholders. In a rights offering, a company's existing stockholders are given the rights to purchase additional shares at a slightly below-market price in proportion to their current ownership in the company.
An important innovation in the sale of securities is shelf registration. Shelf registration permits a corporation to register a large quantity of securities and sell them over time, rather than all at once. The issuer is able to save time and money through a single registration. In addition, these securities can be brought to market with little notice, thereby providing the issuer with maximum flexibility in timing an issue to take advantage of favorable market conditions.
Any trade of a security after its primary offering is called a secondary market transaction. When an investor buys 100 shares of IBM on the New York Stock Exchange, the proceeds of the sale do not go to IBM. They go to the investor who sold the shares.
From an investor's perspective, the function of a secondary market is to provide liquidity of their assets at fair prices. An asset is an item of value owned by an individual or corporation. Liquidity is the speed at which an asset such as stock, bonds, or real estate, can be converted into cash.
Liquidity is achieved if investors can trade large amounts of securities without affecting prices. Prices are said to be fair if they reflect the underlying value of the security correctly.
There are three liquidity-related characteristics of a secondary market that investors find desirable: depth, breadth, and resiliency. First, a secondary market is said to have depth if there are orders both above and below the price at which it is currently trading. When a security trades in a deep market, temporary imbalances of purchase or sale orders that would otherwise create substantial price changes are offset with corresponding orders. Second, a secondary market is said to have breadth if its orders give its market depth in a significant volume. The broader the market for a stock, the greater the potential for stabilization of temporary price changes that may arise from order imbalances. Third, a market is resilient if orders promptly respond to price changes.
There are four types of secondary markets: direct search, brokered, dealer, and auction. Each type differs according to the amount of price information investors have access to.
The secondary market that offers you the least amount of price information is that in which the buyers and sellers have to search each other out directly. For this reason, this is called a direct search secondary market. Because the full cost of locating and bargaining with a willing and capable trading partner is paid by an individual investor, there is only a small incentive to conduct a thorough search among all possible partners in the market for the best possible price. By the time a trade is agreed upon by the two investors, at least one of the participants could have gotten a better price if they were in contact with some other participant they never found. Stocks that trade in direct search markets are the ones people buy and sell so infrequently that a third party, such as a broker or a dealer, has no incentive to provide any kind of service to facilitate this trading. The common stock of smaller companies, especially small banks, trades in direct search markets. Buyers and sellers of those issues must rely on word-of-mouth communication to attract compatible trading partners. The relatively small number of trades makes it difficult to find an economical way of broadcasting quotations or transaction prices. Trades can occur at the same time at quite different prices, and these transactions are usually far from the best possible price.
When the trading of a specific stock becomes sufficiently heavy, brokers begin to offer specialized search services to market participants. For a fee, called a brokerage commission, brokers help find compatible trading partners and negotiate acceptable transaction prices for their clients.
Brokers are most likely to be involved when a lot of investors are in the market because it is more profitable for them. If a broker can fill two customer's orders at a cost less than twice the cost of the direct search that would otherwise be conducted by each of those customers, then brokers will offer their services. This is important because they can profitably acquire the business of both investors by charging a commission somewhat less than the cost of a direct search.
Since brokers are frequently in contact with many market participants on a continuing basis, they are likely to know what a "fair" price is for a transaction. Stock brokers arrange transactions closer to the best available price than is possible in a direct search market. Their extensive contacts provide them with a pool of price information that individual investors could not economically duplicate because of cost. By charging a commission less than the cost of direct search, they give investors an incentive to use the information the broker has.
Even though a brokered market is better than a direct search market, a brokered market cannot guarantee that orders will be executed promptly. Not knowing about the speed of execution creates price risk. While a broker is searching for a trading partner for a client, prices may change and the client may suffer a loss.
As the trading of a stock becomes even more active, some market participants may begin to maintain bid and offer quotations of their own. These traders become dealers. They buy and sell their own inventory at their own quoted prices. Dealer markets eliminate the need for time consuming searches for trading partners, because investors know they can buy or sell immediately at the quotes given by a dealer.
Dealers often sell their stocks at a price greater than the bid price they pay. The difference between the two, called the bid-ask spread, compensates them for providing the liquidity of an immediately available market to occasional participants. This also pays for the risk that dealers incur when they position a security in their inventory. The bid price is the highest price that someone is willing to pay to buy shares of stock. This also means that this is the highest price you can expect to get for your shares of stock when selling them. It is always lower than the ask price. The ask price is the lowest price you can pay for a stock. This is because it is the lowest price any seller is offering their shares for.
Although dealer markets provide investors with the opportunity for an immediate execution of their orders, and although dealer markets can usually be searched more rapidly and cheaply than a direct search or brokered markets, they do have several disadvantages. No one can guarantee that the quotation of a particular dealer could be improved upon by contacting another dealer. This being the case, investors operating in dealer markets have to bear some cost of searching for the best price.
Auction markets provide centralized procedures for the exposure of purchase and sale orders to all market participants simultaneously. In other words, an auction market is a place where anyone who wants to buy and sell can go to. This is important because auction markets virtually eliminate the expense of locating compatible partners and bargaining for a favorable price. The communication of price information in an auction market may be oral if all participants are physically located in the same place, or the information can be transmitted electronically.
Securities not sold on an organized exchange like the NYSE are traded over-the-counter (OTC). A stock may not be listed on an organized exchange for several reasons, including lack of widespread investor interest, small issue size, or insufficient order flow. The OTC stock market is a dealer market. Since different OTC issues are not usually close substitutes for each other, a dealer with limited capital can make a profit with a relatively narrow range of stock inventory. As a result, there is a large number of small OTC dealers. They often concentrate their trading in particular industry groups or geographical areas. It is estimated that about 30,000 various types of equity securities are traded in the OTC market. However, only about 15,000 of these securities are actively traded.
When customers place a buy or sell order for a stock in the OTC market, a broker will contact other dealers who have that particular stock for sale and search out the best price. When satisfied, he or she will complete the buy or sell transaction with that dealer and charge his or her customer the same price plus a commission for the brokerage services.
A major development of the OTC market occurred in 1971 when the National Association of Securities Dealers (NASD) introduced an automatic computer-based quotation system, called NASDAQ. The system offers continuous bid-and-ask prices for the most actively traded OTC stocks. NASDAQ's development accelerated the disclosure of price information, and it also fundamentally altered the structure of the OTC market.
There are three levels of access to the NASDAQ system. Level 3 terminals are available only to dealers and allow them to enter bid and ask quotations for specific stocks into the system. These quotations, together with information identifying the stock and the dealer, appear within seconds on the terminals of other dealers and brokers. For this reason, the NASDAQ always has current prices. Level 2 terminals display all the dealer bid and ask quotations for a given stock, but do not allow that quotation to be changed on the terminal. These terminals are available to brokers and institutions. Level 1 terminals provide only the best bid and ask price (called the inside quote) for a stock. These terminals are used by stockbrokers when quoting prices to their customers.
This greatly increased the efficiency of a broker's search for the best bid-and-ask prices, reducing the amount of trading away from the best available prices.
The New York Stock Exchange (NYSE), the preeminent, biggest and most organized stock exchange in the United States, is an example of an auction market. Other regional stock exchanges in the United States include the American Stock Exchange (AMEX) in New York, the Pacific Stock Exchange in both San Francisco and Los Angeles, the Chicago Stock Exchange, the Philadelphia Stock Exchange, the Boston Stock Exchange, and the Cincinnati Stock Exchange. The NASDAQ and the NYSE account for the vast majority of stock trading. Regional exchanges account for little of the total stock trading volume in the United States.
All transactions in a stock listed on the NYSE and completed within that exchange occur at a unique place on the floor of the exchange, called a post. There are three major sources of active bids and offerings in an issue available at a post: (1) floor brokers executing customer stock orders, (2) limit price orders for stock left with the specialist for execution, and (3) the specialist in the stock buying and selling for his or her own account. Since trading is physically localized, the best available bid-and-offer quotes are very available. Competition and ease of communication among market participants at a post ensure the absence of bids above the lowest offer price or offerings below the highest bid for the stock.
Orders from the public are transmitted by internet, telephone, or telex from brokerage houses to brokers on the floor of the NYSE, who bring the orders to the appropriate posts for execution. Most of these orders are either market orders or limit orders.
A market order is an order to buy or sell at the best possible price available at the time the order reaches the post. The broker bringing a market order to a post might execute the order immediately upon his arrival, or he might hold back all or part of the order for a short time to see if he or she can get a better price than is currently available. He or she may also decide to quote a price on the transaction to reduce the amount of time he or she will have to wait until completing the trade.
A limit order is an order to buy or sell at a designated price or at any better price. Investors place limit orders when they want to buy or sell at a price well above or well below the bid-ask spread. A floor broker handling a limit order to buy at or below a stated price, or to sell at or above a stated price, will usually stand by the post with his order if the limit price on the order is near the current market bid-and-ask prices.
When a limit order is at a price that is not very close to the current market prices (the bid-and-ask), the broker handling the order knows it is unlikely the order will be executed anytime soon. For example, a bid or purchase order at $50 on a stock currently trading at $55 may not be satisfied for days, or even may never be satisfied. As an alternative to maintaining a physical presence at the post, the broker can enter the limit order on the order book maintained by the specialist. No trades can take place at a particular price unless all bids are above and all offerings are below it. In other words, the market has to move up through all of the sell limit orders in the book to hit your sell limit orders. Alternatively, the market has to move down through all other limit orders in the book between your limit order's price before it can be executed. Entering a limit order on a specialist's book is a great alternative to floor brokers who would otherwise have to maintain a physical presence at a post to keep a limit order active.
Specialists provide the third source of bids and offers in listed securities. On the NYSE, Specialists are members of the exchange who are both dealers and order clerks. Specialists have to maintain the price quotations at all times for the issue in which they specialize. Specialists also act as dealers, trading for their own account and at their own risk. NYSE specialists act as order clerks as well, maintaining the book of limit orders for the floor brokers.
Heavy trading volume ensures that there are always active bids and offerings available from either floor brokers or the limit order book. In these cases, the dealer function of the specialist is to be a source of liquidity so that your orders get filled quickly if trading is more sporadic or infrequent. In these cases the obligation of the specialist to provide the liquidity service of immediate execution is vital. Indeed, if the prices of the purchase and sales orders on the specialist's book have a wide spread (which is common for infrequently traded stocks), the specialist may be the sole source of a market for immediate transaction.
Better communications and computer technology have reduced transaction costs, making it easier for other financial intermediaries to compete with securities firms. This has led to the emergence of a so-called "national market" system, online discount trading, 24-hour trading of equity securities, and the globalization of equity markets.
The Securities Act Amendment of 1975 mandated that the Securities and Exchange Commission (SEC), the primary regulator of U.S. financial markets, move toward creating a national market system. In its ideal form, a national market system would have a comprehensive method of recording and reporting transactions regardless of where they take place in the country. It would also be a system that allowed investors to get price information from any exchange instantaneously, and thus a way to buy or sell stock at the best price regardless of location. Progress has been made toward electronically linking the national exchanges, regional exchanges, and over-the-counter markets, but we are still many years away from a truly nationwide system.
There is competitive pressure to link international stock markets as well. Many U.S. firms are issuing stocks on overseas exchanges to take advantage of differences in tax laws, to increase their visibility and reputation, and to avoid flooding local stock markets. In 1986, the London Stock Exchange created a computer network similar to the NASDAQ system and permitted U.S. and Japanese investment firms to enter trades on the system. This development was important because it created a virtual 24-hour global trading environment, given time differences between New York, London, and Tokyo.
Stock exchanges in the United States are panicked about losing business to overseas stock markets. As a step toward increasing the global competitiveness of the U.S. financial markets, the SEC permitted after-hours trading on the NYSE. Before this, trading only took place between 9:30 AM and 4:00 PM Eastern time. The NYSE now has several after-hours trading sessions during which shares trade electronically at the day's closing price. The biggest beneficiaries of the NYSE's move toward globalization will be U.S. companies that expect to broaden the market for their securities.
Unfamiliar market practices, confusing tax legislation and insufficient shareholder communication often discourage investors from participating in foreign stock markets. Many foreign companies overcome these road blocks by means of American Depository Receipts (ADR). An ADR is a dollar denominated claim issued by a bank representing ownership of shares of a foreign company's stock held on deposit by U.S. investors. With over 1,600 ADRs from 63 countries trading in the United States, they are very popular with U.S. investors because they allow investors to diversify internationally.
A sponsored ADR is one for which the issuing foreign company absorbs the legal and financial costs of creating and trading the security. An un-sponsored ADR is one in which the issuing firm is not involved with the issue at all and may even oppose it. Un-sponsored ADRs typically result from U.S. investor demand for shares of particular foreign companies.
Trading in securities in the United States is regulated by several laws. The two major laws are the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1933 act requires full disclosure of relevant information relating to the issue of new stock in the primary market. This act requires full registration of an IPO and the issuance of a prospectus which details the recent financial history of the company, and is concerned only that the relevant facts are disclosed to investors. The 1934 act established the Securities and Exchange Commission (SEC) to administer the provisions of the 1933 act. It also extended the disclosure of the 1933 act by requiring firms with stocks traded on secondary exchanges to periodically release current financial information.
Under the 1934 act, the SEC has the authority to register and regulate securities exchanges, over-the-counter (OTC) trading, brokers, and dealers. The SEC is responsible for broad oversight of secondary markets. In addition, security trading is also subject to state laws.
Stock valuation is a tricky matter and a subject you must understand as a stock investor. To understand stock value you need to understand market capitalization, book value, fundamental analysis, and technical analysis.
Market capitalization is simply the total value of all outstanding shares of a company. To calculate the market capitalization, multiply the total number of shares outstanding of each class of common and preferred stock by its corresponding share price. Assume, for instance, that a company has 1,000,000 shares of common stock outstanding trading at $15 per share and 2,000,000 shares of preferred stock trading at $10 per share. The market capitalization of the company is as follows:
Market Capitalization:
(1,000,000 Shares)($15/Share) + (2,000,000 Shares)($10/Share) =
$15,000,000 + $20,000,000 =
$35,000,000
Book value is the value of the company as shown on the firm's balance sheet. This is the value of everything the company owns less everything it owes. This number may not necessarily reflect the true value of the firm, but it is generally a fair indication.
Fundamental analysis focuses on the company's financial information, including the balance sheet, the income statement, and cash flow statement. The primary concept here is that increased earnings enhance the value of the firm. Since the shareholders are the owners of the firm, the idea is that increased corporate profits increase the share price of the company's stock.
Technical analysis attempts to predict the future direction of stock price movements based on three types of information: historical price, volume behavior, and market sentiment.
Stock market indices provide a useful tool to summarize the vast array of information generated by the continuous buying and selling of stocks. However, the use of market indices presents two problems. First, many different indices compete for attention. Second, indices differ in their composition and can give contradictory information regarding price movements of the stock market.
When constructing a stock market index, the base value and the starting date have to be selected. Only the relative changes in the index values are useful. For example, knowing only that a particular stock market index finished the year at a level of 354.7 is of no value. But if you also know that the same index finished the previous year at a level of 331.5, then you can calculate that the stock market, as measured by this particular index, rose approximately 7 percent over the past year.
The next decision is which stocks should be included in the index. There are three methods for deciding stock market composition: (1) the index can represent a stock exchange and include all the stocks traded on the exchange, (2) the organization producing the index can subjectively select the stocks to be included, or (3) the stocks to be included can be selected based on some objective measure such as market value. Often an index represents the performance of various industry segments such as industrial, transportation, or utilities.
Once the stocks to be included in an index are selected, the stocks must be combined in certain proportions to construct the index. Each stock, therefore, must be assigned some relative weight, usually by share price or market value of the company.
A price-weighted index is computed by summing the prices of the individual stocks in the index. Then the sum of the prices is divided by a divisor to yield the chosen base index value. Thereafter, as the stock prices change, the divisor remains constant.
For example, if the price per share of three stocks in a price-weighted index were $20, $10, and $50 respectively, then the prices would sum to $80. If the base index value is to be 100, then the initial divisor would be 0.8 because 100 = 80/0.8. On the next trading day, say prices per share of the stocks change to $25, $10, and $40. Now the new sum of share prices would be $75 and the price weighted index value would be 75/0.8 = 93.75 or 6.25 percent lower.
A market value-weighted index is computed by calculating the total market value of the firms in the index and the total market value of those firms on the previous trading day. The percentage change in the total market value from one day to the next represents the change in the index.
For example, if the three stocks described in the example above had outstanding shares of 100 million, 200 million, and 10 million, then the total market value for the three stocks on the first day would be $4.5 billion. The total market value on the second day would be $4.9 billion, for an increase of 8.8 percent. If the market value-weighted index began with a a base index value of 10 on the first day, then its value on the second day would be 10.88, or 8.8 percent higher.
The most widely cited stock market index is the Dow Jones Industrial Average (DJIA) which was first published in 1896. The DJIA is a price-weighted index that originally consisted of 20 stocks with a divisor of 20; this means that the value of the index was simply the average price of the original 20 stocks. In 1928, the DJIA grew to encompass 30 of the largest U.S. industrial stocks and includes today such companies as Verizon, Dupont, and Merck.
The New York Stock Exchange Index, published since 1966, includes all of the common and preferred stocks listed on the NYSE. In addition to the composite index, the NYSE stocks are divided into four sub-indices that track the performance of industrial, utility, finance, and transportation stocks. All the NYSE indices are market-value weighted.
The Standard and Poor's (S&P) 500 Index is a value-weighted index that consists of 500 of the largest U.S. stocks from various industries. The stocks included in the S&P 500 account for over 80 percent of all the stocks listed on the NYSE, although a few NASDAQ issues are also included. The index is computed on a continuous basis during the trading day. It is divided into two sub-indices that follow the performance of industrial and utilities companies.
The S&P 400 MidCap Index is market-value weighted and consists of 400 stocks with market values less than those of the stocks in the S&P 500. The S&P 400 MidCap index is useful for following the performance of medium-sized companies.
The S&P 600 SmallCap Index tracks 600 companies with market values less than those of the companies in its S&P 600 MidCap index. The S&P 1500 index includes all of the companies in the S&P 500, the MidCap 400, and the SmallCap 600.
The NASDAQ Composite has been compiled since 1971. It consists of three categories of companies: industrial, banks, and insurance. All of the stocks traded through the NASDAQ are included. In 1984, the NASDAQ introduced two new indices, the NASDAQ/ NMS Composite index and the NASDAQ/ NMS Industrial Index. Both are weighted by market capitalization.
If you don't want to actively buy and sell individual securities, you can invest in stocks, bonds, or other financial assets through a mutual fund. Mutual funds are simply a way of pooling together money of a large group of investors. The buy and sell decisions for the pool are made by fund managers who are paid for the service they provide.
Mutual funds provide indirect access to financial markets for individual investors; these funds are a form of financial intermediary. Mutual funds have a lot of power. They are now the largest type of financial intermediary in the United States, followed by commercial banks and life insurance companies.
As of the end of 2001, about 93 million Americans in 55 million households owned mutual funds, up from 5 million households in 1980. Investors contributed $505 billion to mutual funds in 2001, and total mutual fund assets totaled $7 trillion.
There are two type of mutual funds, open-end and closed-end. Whenever you invest in a mutual fund, you do so by buying shares in the fund. However, how your shares are bought and sold depends on which type of fund you are considering.
With an open-end fund, the fund itself will sell new shares to anyone wishing to buy and will buy back shares from anyone who wants to sell. When an investor wants to buy open-end fund shares the fund simply issues the shares and then the fund manager invests the money received from the investor. When someone wants to sell open-end fund shares, the fund sells some of its assets and uses the cash to redeem the shares. As a result, with an open-end fund, the number of shares outstanding fluctuates over time.
In a closed-end fund, the number of shares is fixed and never changes. If you want to buy shares, you must buy them from another investor. Similarly, if you wish to sell shares that you own, you must sell them to another investor.
A mutual fund's net asset value (NAV) is calculated by taking the total value of the assets held by the fund less any liabilities and then dividing by the number of outstanding shares. For example, suppose a mutual fund has $105 million in assets and $5 million in liabilities based on current market values and a total of 5 million shares outstanding. Based on the value of net assets held by the fund, $100 million, each share has a value of $20 ($100 million / 5 million shares).
Shares in an open-end fund are always worth their net asset value. In contrast, because the shares of closed-end funds are bought and sold in the stock market, the share price is dictated by the market and may or may not be equal to the NAV.
A mutual fund is simply a corporation. Like a corporation, a mutual fund is owned by its shareholders. The shareholders elect a board of directors, and they are responsible for hiring managers to oversee the fund's operations. Every individual fund is a separate company owned by its shareholders.
Most mutual funds are created by investment advisory firms, which are businesses that specialize in managing mutual funds. Such firms have additional operations as discount brokerages or offer other financial services.
An investment advisory firm can create multiple funds. Over time, this process leads to a family of funds all managed by the same advisory firm. Each fund in the family will have its own fund manager, but the advisory firm will generally handle the record keeping, marketing, and much of the research that underlies the fund's investment decisions.
As long as an advisory firm meets certain rules set by the Internal Revenue Service, it is treated as a "regulated investment company" for tax purposes. This is important because a regulated investment company does not pay taxes on its investment income. Mutual funds act as a "pass-through entity" in terms of tax law, funneling capital gains and losses to the shareholders in proportion to their investment.
1. Capital appreciation stock funds seek maximum capital appreciation. They generally invest in companies that have, in the opinion of the fund manager, the best prospects for share price appreciation without regard to dividends or company size. Often this means investing in unproven companies or out-of-favor companies.
2. Growth stock funds seek capital appreciation, but tend to invest in large, more established companies. These funds may be somewhat less volatile as a result. Dividends are an important consideration for the mutual fund manager in purchasing a stock.
3. Growth and income funds seek capital appreciation, but at least part of their focus is on dividend-paying companies.
4. Equity income stock funds focus almost exclusively on stocks with relatively high dividend yields, thereby maximizing the current income on the stock portfolio. The dividend yield is the anticipated dividend divided by the present price of a share of stock.
5. Small company stock funds focus on stocks in small companies. "Small" refers to the total market value of the stock. Small stocks have historically performed very well, at least over the long run, hence the demand for funds that specialize in such stocks. With small-company mutual funds, what constitutes small covers a wide range from perhaps $10 million up to $1 billion or so in total market value, and some funds specialize in smaller companies than others. Since most small companies don't pay dividends, these funds necessarily emphasize capital appreciation.
6. Mid-cap stock funds specialize in stocks that are too small to be in the S&P 500 index but too large to be considered small stocks. Hence, the stocks these mutual funds specialize in are considered to be middle sized stocks or medium sized by market capitalization.
7. Global stock funds have substantial international holdings but also maintain significant investments in U.S. stocks.
8. International stock funds are similar to global funds, but focus most on foreign securities.
9. Index stock funds simply hold the stocks that make up a particular index in the same proportions as the index. The most important index funds are the S&P 500 indexed stock mutual funds which are intended to track the performance of the S&P 500. By their nature, index funds are passively managed and trade only as a necessary to match the index. Such funds are appealing in part because they are generally characterized as low turnover and low operating expenses.
10. Social conscience stock funds are a relatively new creation. They invest only in companies whose products, policies, or politics are viewed as socially desirable. The specific social objectives range from environmental issues to personnel policies. Of course, general agreement on what is socially desirable or responsible is hard to find.
11. Tax-managed stock funds are managed with high regard for the tax liabilities of mutual fund shareholders. Tax-managed stock mutual funds try to hold down turnover to minimize realized capital gains, and they try to match realized gains with realized losses. Fund shareholders have largely escaped taxes as a result.
Exchange traded funds (ETF) are a recent financial innovation. When you purchase an ETF, you are buying the same combination of stocks on a given index. For example, the best known ETF is Standard and Poor's Depository Receipt (SPDR), pronounced "spider," which is based on the S&P 500 index.
What makes an ETF different from an index fund is that it can be traded in the open markets, leaving the possibility for arbitrage. Arbitrage is an activity that involves simultaneously buying and selling a security to take advantage of a price difference in two markets. In plain language, if a company's stock is selling for $12 on the NYSE and $9 on the AMEX, then arbitrageurs will buy the stock on the AMEX and sell the same stock on the NYSE for as much as they can and as fast as they can. The increased buying on the AMEX will cause the price to rise on the exchange while on the other hand the increased selling on the NYSE will cause the price on that exchange to fall until the price is the same on each exchange. In finance we say that arbitrage keeps prices in line by forcing price convergence or one-price for the same asset such as a stock. This is also known as the law of one price.
Hedge funds are a special type of investment company. They are like mutual funds in that a fund manager invests a pool of money for investors and takes his fee off the top. However, unlike mutual funds, hedge funds are not required to register with the SEC. They are only lightly regulated and are generally free to pursue almost any investment style they wish.
Hedge funds are also not required to maintain any degree of diversification or liquidity. They don't have to redeem shares on demand, and they have little in the way of disclosure requirements. The reason that hedge funds avoid many of the restrictions placed on mutual funds is that they only accept "financially sophisticated" investors. They do not offer their securities for sale to the public. Some types of hedge funds are limited to no more than 100 investors.
Hedge funds typically have a special fee structure, where, in addition to a general management fee of one to two percent of fund assets, the manager is paid a special performance fee. A modest fee structure might be one that charges an annual management fee of one percent of the fund's assets plus twenty percent of any profits realized; however, more elaborate fee structures are common.
Whether large or small, each fund develops its own investment style or niche. For example, a hedge fund may focus on a particular sector or global region. Alternatively, a hedge fund may pursue a particular investment strategy, like the market neutral strategy, in which the fund maintains a portfolio approximately equally split between long and short positions. By being long in some securities and short in others, the portfolio is hedged against market risk and said to be market neutral.
Short is a term meaning short selling. This is the sale of a security made by an investor who does not own the security. The short sale is made in expectation of a decline in the price of a security, which would allow the investor to then purchase the shares at a lower price in order to deliver the securities earlier sold short.
Options are securities that make it possible to invest in stocks without actually owning the shares. Options on stock are bought to speculate on price movement. Stock options are themselves securities and can be traded in financial markets. An option to buy a stock is known as a call option or just a call. Options to sell securities are known as put options or just puts.
Options are the most important example of a class of financial assets known as derivative securities. A derivative is so named because it derives its value from the price of another underlying security, in this case the optioned stock.
Investors are interested in stock options because they provide speculative leverage, a term applied to any technique that amplifies the return on an investment. An option's leverage comes from the fact that the return on the investment can be many times larger than the return on the underlying stock.
There are two parties to a contract, a buyer and a seller. The first person to sell an option contract is the person who creates it by agreeing to sell the stock at the strike price. He or she is said to write an option and is called the option writer.
Once the option is written, the option contract becomes a security and the writer sells it to the first option buyer, who may sell the contract to someone else later on. No matter how many times the option is sold, the writer remains bound by the contract to sell or buy the underlying stock to the current option owner at the specified price.
Options are written either covered or naked. With a covered option, the writer owns the underlying stock at the time the option is written. Someone who writes a naked option doesn't own the underlying stock at the time he or she writes the option and therefore faces more risk.
If a stock's current price is below the strike price in the case of a call, or above the strike price in the case of a put, we say that the option is "out of the money" because the option contract buyer could not make any money exercising the contract. If the stock's price is above the strike price in the case of a call, or below the strike price in the case of a put, we say that the option is "in the money" because the option contract buyer could make money exercising the contract.
In general, the option's intrinsic value is the difference between the underlying stock's price and the option's strike price. Investors are willing to pay premiums over intrinsic value for stock options because of the chance that they will earn even more profit. Option premium is the difference between the intrinsic value of the option and the option's price. The exact amount of a particular option's premium above intrinsic value depends on the stock's volatility, the time until expiration, and the attitude of the market about the underlying company.
It's important to keep in mind that options are exercisable over only a limited period at the end of which they expire and become worthless. That makes option investing very risky. For example, if an option is purchased "out of the money" and the option never gets "in the money," the option expires, worthless. The buyer loses the entire price paid for it.
If an option is purchased at a price that includes a positive intrinsic value and the underlying stock goes down in value, the option buyer's loss at expiration is the time premium paid plus the decrease in intrinsic value. As its expiration date approaches, any option's time premium shrinks to virtually nothing. Notice that anyone owning an option with a positive intrinsic value just before expiration must act quickly to avoid losing value.
It's important to note that the options discussed up until now are strictly bought and sold in the secondary market. That is, they're traded between investors, and the companies don't get involved. Specifically, companies don't get any money when the options are written or exercised.
Warrants are similar to call options but are issued by the underlying companies themselves. When a warrant is exercised, the company issues new stock in return for the specified price. Warrants are therefore primary market instruments. Warrants are like call options in that they give their owners the right to buy stock at a designated price over a specified time period. They differ from stock options in that the time period is much longer, typically several years.
Warrants are usually issued in conjunction with other financing instruments as "sweeteners" to make the primary security more attractive. For example, suppose a company wants to borrow, but isn't in good financial condition, so lenders have rejected its bonds. They may be induced to buy the company's bonds if the firm attaches one or more warrants to each bond giving the holder the right to buy a share at $50 within the next five years. The warrants provide incentives to buy the bonds if people think the stock is likely to go over $50 before five years have passed. If bond holders do exercise the warrants then the company will receive additional cash as they issue new shares that are sold to fulfill the warrants.
Warrants can generally be detached and sold independently at a market value of their own. This effectively reduces the price of the bonds and increases their yield to the investor. Alternatively, bondholders can keep the warrants and exercise them for a quick gain if the stock's price rises above $50. Notice that if the warrants are exercised, the company receives an equity infusion based on a price of $50 rather than the higher market price. The bonds are unaffected by the exercise of the warrants.
For many years, American companies have given certain employees stock options as part of their compensation. Companies like paying with options because they don't cost anything when issued. Since employees who receive options get lower salaries, the practice improves the company's financial statements by lowering payroll costs. Beyond that, supporters maintain that the employees will be more motivated to act in the best interest of the company, since the value of their options are directly tied to market price.