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Fundamentals of Investing Questions by qul96690


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13.1   The article suggests the following approach to having an organized system. First step would be
       organize the paperwork by each brokerage firm and mutual fund. Next list all of your assets
       categorized by asset categories. Across the top, make columns for cash, domestic bonds,
       international bonds, domestic stocks and so on. Use rows for the source such as ABC mutual
       fund and brokerage firm. Add up all of your assets by category, and calculate the percentage of
       your portfolio for each asset category.

       Having an organized system of the portfolio composition would help an investor to make a
       informed investment decision that fits into his overall investment strategy. The organized records
       would also provide information on securities sold during the year and would be a major benefit
       during tax filings.

13.2   It is generally recognized that given favorable levels of income a younger investor would seek
       growth-oriented, longer-term, capital- gains investments. As an investor ages, more secure
       investment returns are sought. Finally, at retirement the investor will want secure income-
       producing investments.
       a. The retired investor would probably hold secure, income-producing securities with low risk.
       b. The high- income, financially secure investor would hold a diversified, growth-oriented group
            of securities providing capital gains and favorable tax treatment.
       c. A young investor with a secure job and no dependents would probably hold a combination of
            diversified income-producing securities and would depend on the investor's tax bracket and
            need for additional current income. If the investor needs little or no additional current
            income, the securities would be primarily growth-oriented offering expected capital gains.

13.3   It is important for an investor to continuously manage and control his or her portfolio to be sure
       that investment goals are being met. Over time, the securities in the portfolio may change their
       investment characteristics, thereby changing the character of the portfolio. If the portfolio
       performance is inconsistent with its goals, it should be adjusted and revised to remain consistent
       with the investor's needs. The management and control process involves assessing actual
       performance, comparing it to planned performance, revising and making needed adjustments,
       and timing these adjustments to achieve maximum benefit.

13.4   Current market information, such as share price, dividend yield, and similar return data, are
       critical to performance evaluation. Regularly checking this data, as well as following a
       company's earnings, dividend payments, and general news, provides a way to monitor stock
       performance and decide whether the investment should be held. Changes in economic and
       market activity can affect the level of current income and the market value of each investment
       vehicle differently. For some investment vehicles, such as real estate, local economic activity is
       most important. Bonds may be most affected by nationwide economic conditions. Gold is most
       affected by international economic and political conditions. Sources of economic information
       include large regional banks, New York City banks, The Federal Reserve Banks, and investment
       services. All investments are affected by nondiversifiable risk which is tied to changes in market

13.5  In evaluating the performance of his or her portfolio, an investor should compare it to some
      measure of general market returns. For stocks, one could use the Dow Jones Industrial Average.
      However, it is actually not considered the most appropriate gauge of stock price movement.
      Including only thirty stocks, it is not broad based. A better index is the Standard and Poor's 500
Fundamentals of Investing, by Gitman and Joehnk                                                        1
       Stock Composite Index or the New York Stock Exchange Composite Index. For bonds, the Dow
       Jones Composite Bond Average or data from Standard & Poor's, Moody's, and/or the Federal
       Reserve are appropriate. Real estate returns are more localized. Therefore, in real estate markets
       one would analyze local returns. This information may be available at local real estate boards
       and/or agencies. The investor should probably distinguish between income property and
       undeveloped property.

13.6   A bond market indicator is information and/or an index which reflects the general behavior of
       the bond markets. Where stock indexes are presented relative to an original base, bond indexes
       are stated relative to the bond's par, or face, value or as the yield to maturity. The Dow Jones
       composite bond average is a popular measure of bond price behavior. It is based on the closing
       prices of ten utility and ten industrial bonds. This average is published daily in The Wall Street
       Journal and weekly in Barron's and reflects the average percentage of the face value at which
       the bonds sell. Bond yield data may also be obtained from Standard & Poor's, Moody's Investors
       Service, and the Federal Reserve, and is also published in The Wall Street Journal and Barron's.

13.7   The dividend yield measures the current yearly dividend return earned from a stock investment.
       It is calculated by dividing the stock's yearly cash dividend by its price. The holding period
       return (HPR), on the other hand, measures the total return (income plus change in value) earned
       on an investment over a given investment period. The change in value (capital gain or loss) need
       not be realized to be considered in HPR. The dividend yield and the HPR are not equivalent.
       They are equal only when the price of the stock is the same at the end of the period as it was at
       the beginning of the period.

13.8   Mutual funds pay investment income dividends and capital gains dividends. Income dividends
       are derived from the interest and dividends received by the fund, while capital gains dividends
       are a result of gains net of losses realized by the fund on its security purchase and sale
       transactions. These dividends are not the only source of return on a mutual fund investment; the
       other source of return is a change in the value of the mutual fund which is attributable to
       unrealized gains that exist in the portfolio.

13.9   An investment holding is a candidate for sale when:
       1. It fails to perform as expected and no major change in performance is anticipated.
       2. It has met the original investment objective.
       3. The investor now has better investment opportunities available for the funds.

       A risky investment must provide a higher return than a low-risk investment to attract a rational
       investor, who must be compensated for taking the additional risk.

13.10 A problem investment is one that has not lived up to expectations. Either the investment has
      experienced a loss, or has provided an actual return less than the investor expected.

       When analyzing an investment portfolio, the investor should first ask: “Has the investment
       performed reasonably in light of initial expectations?” The second question is: “Would the
       investment be included in the portfolio today if it were not already there?” If the answer to both
       questions is “no” for a specific investment, it should probably be sold. A negative answer to one
       of the questions indicates that the investment is a “problem investment” and should be watched

13.11 Active portfolio management is the process of building a portfolio using traditional and modern
      portfolio approaches and then managing and controlling it to meet investment objectives. Active
      management should improve the returns earned on the portfolio. This contradicts the efficient
Fundamentals of Investing, by Gitman and Joehnk                                                        2
        market hypothesis, which states that markets are so efficient that available information about a
        company and/or its securities is always fully reflected in the security's price. If this were true,
        investors could not expect to consistently outperform the market by managing their portfolios.

13.12 Portfolio performance is measured by calculating the holding period return (HPR) for the
      portfolio. This involves (1) measuring the amount invested, (2) measuring income, (3) measuring
      capital gain, and (4) combining these components to find the portfolio's HPR.

        The HPR formula includes both realized returns (income plus realized capital gains) and the
        unrealized capital gains of the portfolio. Further, portfolio additions and deletions must be time-
        weighted for the number of months they are in the portfolio. Unrealized capital gains are those
        that have not yet been received. Realized capital gains, on the other hand, are the capital gains an
        investor has received from sale of particular securities. An unrealized capital gain can become a
        capital loss when economic conditions change drastically.

13.13 Many year-end statements by brokerage firms and mutual funds do not provide performance data
      for a couple of reasons. First of all, it would be a lot of work and a lot of computer programming
      time to get the performance results. Secondly, the result might just be poor which would reflect
      badly on the fund manager or broker.

        In order to compute the portfolio returns correctly, you need to know the exact timing of any
        additions or withdrawals you made during the year. Your total gain during the year would be
        your ending balance minus your beginning balance minus your additions to your portfolio. The
        appropriate bench mark indexes would be the S&P 500 Stock Composite Index for large
        domestic stocks, the Morgan Stanley EAFE Index for international stocks, the Russell 2000
        Index for small U.S. stocks, or the Lehman Brothers Bond Index for a Bond Portfolio.

13.14 Once the HPR for the portfolio is calculated, the return figure should be utilized in a risk-
      adjusted, market-adjusted rate of return analysis. This type of comparative study can be very
      useful because it provides the investor with insight into how his or her portfolio is performing
      relative to the stock market as a whole. Comparing the return to a broad market index does not
      take risk into account.

        a. Sharpe's measure compares a portfolio's risk premium to its standard deviation of return to
           assess the risk premium per unit of total risk. The formula is:

           Sharpe's measure = Total portfolio return – Risk- free rate = rp – RF
                 (SM)             Portfolio standard deviation              sp

        Once calculated, Sharpe's measure can be compared to the Sharpe's measures of other portfolios
        or the market. If the portfolio's SM is higher, it is performing better than the other portfolio or
        the market.

        b. Treynor's measure also measures the risk premium per risk unit but uses beta rather than the
           standard deviation to do so. It focuses on nondiversifiable risk only and is calculated as

          Treynor's measure = Total portfolio return – Risk- free rate = rp – RF
                (TM)                      Portfolio beta                    bp

Fundamentals of Investing, by Gitman and Joehnk                                                           3
        Using the TM, an investor can compare her or his portfolio to the market or to another portfolio.
        A higher TM indicates better performance.

        c. Jensen's measure, also called alpha, uses portfolio beta and the capital asset pricing model
           (CAPM) to calculate the excess return—the difference between the actual return and the
           required return. The excess return may be positive, negative, or zero and is calculated as

        Jensen's measure    = (Total portfolio return – Risk-free rate) – [Portfolio beta ? ?
?       ?                   ?          (alpha) (Market return – Risk- free rate)]

        JM                  = (rp – RF) – [bp – (r m – RF)]

        Positive JM values indicate the portfolio earned more than its risk-adjusted, market-adjusted
        required rate of return; a JM of zero means the portfolio earned its required return; negative
        values mean the portfolio fell short of its required return.

13.16 Jensen's measure is similar to Treynor's measure; both focus only on nondiversifiable risk by
      using beta. Jensen's measure is preferred because it automatically adjusts for market return
      through its use of the CAPM. This eliminates the need to compute a measure for the market; no
      further comparison is necessary. As with the other two measures, the higher the JM value, the
      better the portfolio is performing.

13.17 When an investor decides to change the composition of a portfolio by selling some securities and
      replacing them with others, he or she is engaging in portfolio revision. Periodically, the investor
      must check to see if the portfolio continues to meet his or her needs. Such dynamic portfolio
      management requires portfolio revision.

        As economic conditions and individual priorities change, an investor must revise the portfolio by
        reallocating and rebalancing it. As the risk-return characteristics of the securities change, the
        investor should eliminate issues that no longer meet his or her objectives. Also, portfolio revision
        may be needed to maintain an adequate amount of diversification. All these situations require
        managing, controlling, and possibly revising the portfolio.

13.18 Formula plans are mechanical methods of portfolio management that try to take advantage of
      price changes in securities that result from cyclical price movements. Formula plans, part of a
      conservative strategy, are designed primarily for investors who do not wish to take excessive risk
      but wish to quickly and favorably adjust their portfolio in response to cyclical security price

        a. The dollar cost averaging plan involves investing a fixed dollar amount in a security at fixed
           intervals. This is a passive buy-and- hold strategy in which a periodic dollar investment is
           held constant. If the share price increases, fewer shares are purchased. When the share price
           declines, more shares are purchased. The hoped-for outcome is growth in the value of the
           selected security.
        b. A constant-dollar plan uses a two-part portfolio. The speculative portion is invested in
           securities having high promise of capital gain. The conservative portion consists of low-risk
           investments such as bonds or money market accounts. If the speculative portion of the
           portfolio rises a certain percentage or amount in value, the constant dollar plan uses its profits

Fundamentals of Investing, by Gitman and Joehnk                                                            4
          to increase the conservative portion. If the speculative portion declines in value by a
          specified percentage or amount, funds are transferred to it from the conservative portion.
       c. The constant-ratio plan establishes a desired fixed ratio of the speculative to the conservative
          portion of the portfolio. An individual rebalances the portfolio whenever the actual ratio
          differs from the desired ratio by a predetermined amount. With this plan, an investor must
          decide what is the appropriate target ratio of the two portions of the portfolio and how far
          from the target ratio the actual ratio should be permitted to stray before one rebalances the
          portfolio. Since one expects the speculative portion of the portfolio to increase in value more
          rapidly than the conservative portion, this strategy should function much like the constant-
          dollar plan.
       d. The variable-ratio plan is a more aggressive strategy. The target ratio between the
          speculative portion and the conservative portion of the portfolio is varied by the investor and
          depends on the expected movement in value of the speculative securities. If the investor feels
          the market movement will be generally upward, he or she increases the proportion in
          speculative vehicles. If the feeling is bearish—a downward market—the proportion in
          conservative vehicles is increased. This strategy is not only the most aggressive but also
          requires more effort by the investor.

13.20 A limit order can be used to specify the investor's minimum sell price or the maximum price the
      investor will pay to buy the security. The stop-loss order is a type of suspended order that
      requests the broker to sell a security at the best available price only if it trades at a specific price
      or lower. A stop- loss order is a particular kind of a limit order that becomes a market order to sell
      if a stock trades at the trigger price or lower.

       If an investor issues a stop- limit order to sell a security with a limit price above the initial
       purchase price, the investor “locks-in” or protects the profit she has earned. If the investor issues
       a stop- limit order to sell a security with a limit price below the initial purchase price, the investor
       effectively puts a floor on potential losses.

13.21 The first reason investors should maintain some funds in a low-risk, highly liquid investment is
      simply to protect against the chance of a total loss. Thus, a low-risk investment acts as a buffer
      against possible investment adversity.

       Second, highly liquid investments can provide funds for use in pursuing future opportunities. A
       sudden change in economic conditions might make it conducive for an investor to invest more
       heavily invest in the stock market. In such situations, a highly marketable investment can readily
       be converted into cash and the proceeds invested in the stock market. An investor with liquid
       funds can take advantage of these opportunities without disturbing the existing portfolio.

13.22 The two considerations in timing investment sales are tax consequences and compatibility with
      investment goals. When there is a capital loss, the investor receives the benefit of a tax
      deduction. In particular, capital losses provide tax benefits by offsetting capital gains and thereby
      lowering the investor's tax liability. From the point of view of investment goals, a security should
      be sold if it no longer meets the needs of the portfolio's owner. For example, if a particular
      security increases the risk of the portfolio to an extent that it is undesirable, that security should
      be sold in the marketplace. Although taxes are important, one should not forget that the dual
      concepts of risk and return remain the overriding concerns in the portfolio management and
      administration process.

Fundamentals of Investing, by Gitman and Joehnk                                                              5

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