Some Basic Investment Terms and Ideas
by Joseph W. Trefzger
Professor of Finance
Illinois State University
Updated February 10, 2002
The following definitions should be helpful to individuals beginning their study of the investment markets.
The definitions are not taken from textbooks, but rather are phrased in general, non-technical language
that stresses practical concerns. This introductory coverage does, in some cases, simplify concepts or omit
some details; the reader seeking a more thorough discussion may consult investment textbooks or various
business/financial publications. The terms are presented somewhat in a “building block” sequence, rather
than in alphabetical order.
Investment: Economists see investment as spending by a business on buildings,
machines, computers, vehicles, etc., in the expectation of making a financial return.
Informally, people also think of “investing” as what households do when they direct
money to various media (usually places other than bank savings accounts) in the
expectation of making financial returns. (Economists view any commitment of money
by the household sector as a form of savings.)
Security: When we discuss securities, we usually are talking about bonds and stocks.
A security is a rearrangement of claims on real estate or personal property, usually
undertaken to shift risks to parties more willing or able to deal with them. For example,
I could buy a $50,000 truck and deliver canned soup to grocery stores, facing all the
risks that could befall a single truck and a delivery business. Or I could give $50,000 to
Campbell’s. They could use the same $50,000 to buy the same soup truck. But I would
receive a piece of paper (security) giving me a more stable “piece of the action” with
regard to that company’s entire operation.
Portfolio: A combination of stocks, bonds, and perhaps other securities selected because
they behave well together, reacting differently to changing economic conditions. The
idea is to diversify, so that you do not have “all your eggs in one basket.”
Bond: A security representing a lender’s claim against a business (often, but not always,
a corporation) or an agency of government. Bondholders are entitled to receive interest
(usually every six months) plus a return of the principal lent (usually repaid at the stated
maturity date). If the borrower is a business, the bondholders are paid the amounts they
are entitled to receive before returns are paid to the owners. For this reason, it is usually
said that a corporation’s bonds constitute a less risky investment than does its stock.
Of course, you would not lend money to a person, business, or government agency unless
you 1) were able to investigate that party’s credit-worthiness, 2) received some written
promises before handing over the money, and 3) could then monitor the borrower’s
spending activities. But an individual investor would find it very difficult to handle such
matters when dealing with a large firm located far from the investor’s home.
So to attract money from investors nationwide when it issues bonds, the borrowing
company or agency creates a complex legal document called an indenture that carefully
spells out what the borrower will do to protect the lenders’ investment (for example,
whether any real estate or machinery serves as collateral on the loans). Then the borrower
hires a knowledgeable trustee (typically the trust department of a major bank) that,
although paid by the borrower, has a legal duty to make sure the borrower complies with
the indenture provisions that protect the lenders (bondholders).
Finally, the firm borrowing the money pays a reputable financial analysis firm [Moody’s,
Standard & Poor’s] to analyze its business activities and the indenture, and to rate the
bonds for credit quality (a rating such as AAA, BB, or D is assigned). If the reported
credit quality is low, lenders insist on receiving a higher interest rate (just as consumer
finance companies that lend to people with poor credit histories charge higher interest
rates than conservative banks do).
Corporation: A form of business organization that treats the owners as separate from
the business (contrast with proprietorships and partnerships, which legally are financially
indistinct from their owners). So an important feature is that the owners of a corporation
have limited liability; they can be held financially responsible for the corporation’s
financial obligations only up to the amount they have already contributed. (If a
corporation goes bankrupt, its owners do not have to deplete their savings or sell their
homes to repay workers, lenders, or other people who are owed money.)
A corporation can be closely held (owned by a limited number of people, possibly family
members of the founders) or publicly traded (in which case anyone can become an owner
by contacting the firm or one of its current owners, typically with the assistance of a stock
broker). [There are more than 6,500 publicly traded US corporations.] As an investor,
you generally are not interested in closely-held firms, of which you can not currently
become an owner. However, such firms sometimes do “go public” in initial public
offerings, and when these “IPOs” involve interesting firms they can generate great
enthusiasm among investors. (IPOs sometimes get a lot of publicity, but there is much
uncertainty, which causes these situations to present big investment risks.) Now we even
see some “DPOs,” or direct public offerings, in which growing companies sell shares
directly to investors over the Internet, in order to save the money that would otherwise be
paid as a fee to a “Wall Street” investment banking firm.
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Common Stock: A security representing ownership in a corporation. Common
stockholders are the true owners of a corporation; they are entitled to residual values
(amounts left after all other parties have been paid), in the form of cash payments called
dividends and stock price increases called capital gains. Because the owners do not
receive financial returns until all others with claims (workers, suppliers, lenders, taxing
bodies, all of whom receive fixed payments) have been satisfied, a corporation’s common
stock is generally viewed as a riskier investment than its bonds. But because the owners
then get to keep whatever is left, which could be a very large amount (or – at the other
extreme – nothing at all), common stock offers the potential for very high returns.
For a large, publicly-traded corporation, there can be thousands (or even millions) of
individual ownership pieces, or shares of common stock, that can be bought or sold.
An individual investor might own anywhere from a fraction of one share to thousands
(or even millions) of shares. Typically, common stock transactions involve the sale/
purchase of 100-share blocks, known as round lots.
Rate of Return: A combination of the yield and the growth (or decline) in value over a
measured time period, usually a year. (In fact, even if the instrument does not have a one-
year life, we typically convert its computed rate of return to an annual equivalent so that
we can compare returns on different types of “investments”). Therefore, for common
stock, the measured (or expected, if we are projecting for the future) rate of return is the
measured (expected) annual dividend [total of four quarterly payments] as a percentage
of the stock’s price at the beginning of the measured period, plus the measured (expected)
percentage change in the stock’s price over the measured period.
For example, let’s say that the market price of a share of some company’s stock was $50
on January 1, 2001. If 1) you bought a share for $50 on January 1, 2001; 2) during 2001
you received $2.00 in total dividends; and 3) the market price of the stock on January 1,
2002 – a year later – was $54 per share, then your total 2001 rate of return is computed as
dividend yield plus percentage change in price, or $2/$50 + $4/$50 = $6/$50 = 12%. If
the stock had been selling on January 1, 2002 for only the original $50 purchase price,
then the total 2001 rate of return would have been $2/$50 + $0/$50 = $2/$50 = 4%. If the
stock had been selling on January 1, 2002 for only $48 per share, then your rate of return
would have been $2/$50 minus $2/$50 = 0%, with the dividend received simply canceling
out the loss in value. (Question: if you actually bought the stock way back in 1985 for
$26 per share, how would we measure your 2001 rate of return?)
An interesting implication of this breakdown is that the stock market does not have to
plummet for investors to be hurt. For example, even if stock prices simply remain where
they are, stockholders can lose to the extent that the dividend yield (recent average of
about 1.3%) is less than the interest rate that could have been earned on a certificate of
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deposit at a bank. The average annual rate of return on the stock market, as measured by
people who look at companies’ results over long periods of time, is generally said to be
about 12%. This number is far less than the 25%-plus figures seen in the late 1990s until
the market reached an all-time high early in 2000. Because the 12% is average, we
expect to see some years above 12% and some below (the return can even be negative, as
in 2001). We also might ask whether someone who has computed a 12% (or other) long-
term average return has accounted for survivorship bias, the idea that if we measure the
long-term returns only of today’s existing companies we are overestimating returns by
ignoring the bad experiences of all the companies that went out of business.
Board of Directors: A small group of a corporation’s most influential common
stockholders, elected by their fellow stockholders (or sometimes appointed) to make
major strategic decisions. The directors, in turn, choose one from their midst as Chair of
the Board (and sometimes, especially in very large corporations, another as Vice Chair).
The Board deals with strategic issues (like whether the company should sell products in
foreign countries, or whether the common stockholders should withdraw company money
as dividends); and it hires, and then monitors the actions of, operating managers (people
like the President and various Vice Presidents, who oversee such day-to-day decisions as
whether to hire more welders, or whether to buy electrical parts from a new supplier).
In a large corporation, the elected Chair typically serves in a full-time capacity, and
collects a high salary, overseeing company strategic matters. The full-time Chair of a
large corporation might hold the title “Chairman and Chief Executive Officer” (that’s
what a “CEO” is). The President, appointed by the Board, might hold the title “President
and Chief Operating Officer.” It is not unusual for the President to be a protégé of the
Chair, who eventually succeeds the Chair when the latter retires.
Board members can be insiders (Presidents and Vice Presidents typically own a lot of
their firms’ common stock, and often serve on the Boards as well as holding operating
manager jobs) or outsiders (perhaps top managers of other companies). There have been
controversies in recent years when Boards controlled by insiders were accused of making
decisions that benefited (or simply gave too much power to) the Chair, President, and
other insiders at the expense of the common stockholders’ overall long-run best interests.
Controversy also arises because Board members for large corporations are paid tens
(or even hundreds, as in the infamous Enron case) of thousands of dollars per year,
sometimes in return for simply attending a few meetings; and because some high-profile
people serve on the Boards of many corporations, collecting huge fees while having little
time to devote to fulfilling their obligations to specific companies.
Trefzger/Investment Basics/2-10-02 4
Seeming “outsiders” can be, in effect, insiders if they are closely allied with the Chair,
President, or other powerful insiders and will unquestioningly follow their wishes. This
situation can arise if a Director had lacked the stature to be elected or appointed to the
Board without the Chair’s/President’s support, or if the “outsider” leads an organization
that sells its goods to, or otherwise benefits from, the firm on whose Board she serves.
One concern might be that too much in company resources would go to paying top
officers’ salaries and benefits, leaving too little as a financial return to the common
stockholders. (A counter-argument is that a more cohesive Board can act more quickly
and decisively in the stockholders’ interests when crises arise.)
Preferred Stock: A “hybrid” security issued by a corporation, with some similarities to
common stock, but with more similarities to bonds. For income tax reasons, individual
investors typically do not buy preferred stocks (other corporations do).
Derivative: A security whose value is derived from the value of another security (often
a share of stock), or from some economic measure (like interest rate movements or the
price of wheat). Commonly known examples of derivatives are options and futures.
Beginning investors tend to avoid derivatives because of the high risks that can be
involved, although some strategies involving options (the right to buy or sell stock at
a stated price) can help the investor – for a price – to reduce risks or lock in gains.
Annual Meeting: A general meeting of a corporation’s common stockholders, which
by law must be held annually. The Chair calls the meeting so that stockholders can elect
Directors and vote on other important issues (typically casting one vote for each share
owned) and question top managers on corporate activities. The holder of a small amount
of stock typically does not go to the meetings (some firms are said to hold meetings in
mundane locations so that most investors will stay home), instead signing a proxy
statement that allows either the Board or else a Board-challenging dissident group of
stockholders to vote in her place.
Annual Report: A publicly-traded corporation’s yearly statement to its shareholders and
the public. The report contains some useful objective information, such as the Balance
Sheet and Income Statement audited for fairness and accuracy by a CPA firm. It also
contains management’s discussion of the policies that it has followed in the past and that
it intends to follow in the future. But the report can be, in many respects, a public
relations tool: a glossy magazine in which the company “toots its own horn.”
10-K Report: A publicly-traded corporation’s annual report of financial statement and
other information to the Securities and Exchange Commission (SEC, the federal agency
that oversees the securities markets). Whereas the Annual Report can be criticized as a
“puff piece,” the 10-K must report any corporate “dirty laundry” that might be of interest
Trefzger/Investment Basics/2-10-02 5
to federal regulators (for example, whether any corporate officers are under indictment).
Serious investors like to look at the 10-K instead of, or more typically in addition to, the
Annual Report. (A less detailed 10-Q report is filed quarterly with the SEC, as well.)
Institutional Investors: Large organizations that collect small amounts of money from
(or on behalf of) many individuals and then put the resulting large dollar amounts into
large-scale investments. Each individual who supplied money has a proportional claim
on investment returns earned. The best known examples are Pension Funds and Mutual
Pension Fund: A pool of money created to provide retirement incomes for a specific
group of people, typically organized by a firm that regularly contributes on behalf of its
employees. Because Pension Fund investments must be of a prudent nature under the
provisions of the federal Employee Retirement Income Security Act of 1974 (ERISA), the
corporate bonds and common stocks that Pension Funds buy tend to be those of big, well-
known companies. Many people who do not think of themselves as investors do, in fact,
benefit from investments in stocks and bonds indirectly, through their Pension Funds.
Mutual Fund: A pool of money that has grown large through the voluntary contributions
of many small investors, who seek the benefits of investment diversification and/or
professional money management. Existing mutual funds provide a wide range of
investment choices, ranging from aggressive growth stocks, to stodgy “blue chip” stocks,
to bonds, to combinations of security types, including stocks of foreign corporations. The
typical Mutual Fund requires a new investor to contribute about $2,500 ($500 if for an
Individual Retirement Account), but amounts can vary considerably from fund to fund.
Each investor has a proportional claim on the investment returns the Mutual Fund earns,
but those returns are reduced by fees paid to the money manager. The money manager
has to be paid regardless of how the investor got into the fund. The investor might also
have to pay a commission, or “load,” to a stock broker for putting her money in the fund.
However, there are still many “no-load” funds, to which the investor sends her money
directly, bypassing the broker and the commission. “No-loads” are selected by many
people who do not feel they need the advice of brokers in setting investment objectives
and finding suitable Mutual Funds. (An increasing number of major companies also
allow investors to buy stock directly from them, without having to pay brokerage
commissions; these stocks are known as “no-load” stocks.)
One problem with mutual funds is the income tax issue; capital gains the fund realizes
from selling stock are passed along to you as a shareholder in the fund, even if you have
not sold any of your shares in the fund. So you might get a hefty income tax bill even if
you have not personally bought or sold anything during the year, and even if your fund
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shares have fallen in value (as happened to a lot of people at the end of 2000, when their
shares were worth far less than the early-2000 high, but the fund had capital gains
because the stock it sold in 2000 that had been purchased at low prices in earlier years).
One solution to this problem is to hold mutual fund shares, especially in funds that do not
follow a policy of being “tax efficient” (careful to avoid this type of tax headache for the
fund shareholders) only in a Roth IRA or other non-taxed plan.
Fundamental Analysis: Making a stock market investment decision by studying a
firm’s ability to generate sales and to make earnings, under the economic conditions
expected to prevail in the “foreseeable” future. [Viewed as questionable by some
academics, for reasons that include the difficulty of interpreting the numbers in
companies’ accounting statements. This effect has been seen in recent years with
Sunbeam, Xerox, Enron, and other prominent companies whose high reported profits
turned out to have been exaggerated through tricks that even CPAs and Wall Street
analysts could not figure out.]
Technical Analysis: Making a stock market investment decision by studying a chart
of past movements in a firm’s stock price, looking for repeating patterns that might be
helpful in predicting future price movements. [Largely disreputable among academics.]
Efficient Markets: The theory that no one can consistently choose stocks that will “beat
the market,” especially after paying brokerage fees. The logic is that: 1) Stock prices
move in reaction to important information that investors learn about the affected
companies. 2) Institutional investors and major financial advisory firms study the
activities of large publicly-traded firms in minute detail. Their buy/sell decisions or
recommendations therefore are already based on all information that should affect a
particular common stock’s price. So if the theory holds true, you can’t find “underpriced”
or “overpriced” stocks. The reasoning is that the currently quoted price, determined
through the buying and selling activities of well-informed/advised investors, should
contain all information that anyone (other than corporate insiders, for whom it is illegal
to trade based on secret inside information) could hope to learn.
One implication is that, because past price movements can not tell you anything about the
next piece of information that will hit the news wires, technical analysis does not work.
Another implication is that the “smart money” already knew and acted on important news
by the time you could read about it in the Wall Street Journal, or even locate it in an on-
line source, so fundamental analysis can not help the small investor. (Of course, if there
were not professionals doing fundamental analyses, the markets could not be efficient.
Still, by looking at the same information and competing with each other, these market
Trefzger/Investment Basics/2-10-02 7
pro’s all tend to come up with the same types of recommendations, so no one beats a
diversified “buy and hold” strategy in the long run.)
Finance professors generally believe, based on many careful studies, that the market for
publicly-traded common stocks is reasonably efficient, especially with regard to big
corporations that so many institutional investors and professional analysts regularly study.
So a typical academic view is that technical analysis is useless, and that fundamental
analysis might be helpful for individual investors only with regard to smaller corporations
whose stocks are not actively studied by institutional investors and major investment
advisory firms. Professional investment advisors, especially technical analysts, obviously
tend to disagree with the idea that the markets are efficient.
Wall Street: 1) The street in the financial district of New York City where the New York
Stock Exchange and many major investment firms are located. 2) A metaphor (more
technically, a synecdoche) for the U.S. financial marketplace. A news story about “Wall
Street’s” reaction to some event might actually be based on a reporter’s discussions with
investment analysts in Boston, Denver, San Francisco, or even Bloomington.
Primary Market: The market for newly-issued bonds or shares of stock. When a
corporation wishes to raise new money, it creates new securities and undertakes a primary
market offering. It does so with the help of its Investment Banker, a financial firm that
advises the corporation and then, in many cases, purchases all of the bonds or shares (an
activity called underwriting). That way, the corporation immediately gets the money it
needs to pay for new machines, etc. Then the Investment Banker (Merrill Lynch, for
example) sells the bonds or shares to the investing public through its brokerage network.
It hopes to sell the securities at a price slightly above what it paid to the corporation, in
order to cover its costs and make a profit.
Secondary Market: The huge market for previously-owned bonds or shares of stock.
The securities therefore are bought/sold between investors; the issuing corporation
receives no money from secondary market transactions. Yet corporations pay large fees
to have their stocks traded on the stock exchanges that facilitate the secondary market.
Why? Because if investors did not have the assurance of being able to sell their bonds or
shares when they later chose to do so, they would have to think twice about ever buying
securities in primary market offerings, and corporations’ ability to raise new money
would disappear. When the day’s stock market activity is noted on the evening news,
the reporter is talking about the secondary market.
New York Stock Exchange (NYSE): A large New York City financial institution that
provides a centralized location for secondary market transactions, where stock brokers
nationwide help their clients to buy or sell stocks of (most of) the biggest U.S. firms
Trefzger/Investment Basics/2-10-02 8
[ADM, Caterpillar, Dynegy, GM, P&G, Kellogg’s]. The American Stock Exchange
(ASE) in New York City performs a similar function for firms that are big, but typically
not big enough to be household names. Regional exchanges (like the Chicago Stock
Exchange) perform the same function for smaller publicly-traded corporations (while
selling the shares of “dually listed” large companies as well). However, some stock, even
for very large firms [Microsoft, Dell, Intel], is not listed on the NYSE or other exchanges,
but rather is traded only through the computerized NASDAQ “Over-the-Counter”
market that puts investors in touch with dealers (investment firms that hold inventories
of stocks, some thinly-traded but others very actively traded) nationwide. (The NASD, or
National Association of Securities Dealers, now owns the American Stock Exchange as
Dow Jones Industrial Average (DJIA): Our oldest measure of stock market strength
(established in 1896), based on the stock prices for a small sample (originally 12, but
since 1928 it’s been 30) of large American firms in the manufacturing, financial, and
service sectors of the economy. In theory, this number is simply the average price of
those 30 stocks at the close of trading (average across various exchanges) on a given day.
In practice, the number is more complicated to compute because 1) Dow Jones makes
occasional changes in the list of firms that makes up the index, but adjusts its numbers
so that the index does not change merely as a result of the switch, and 2) the equation
has to be changed when a firm in the index gives more shares of stock (stock “splits” or
“dividends,” not to be confused with cash dividends) to its current common stockholders.
The DJIA’s original level in 1896 was 40.94; it took until 1972 to reach 1,000 and until
1991 to reach 3,000. But then the “Dow” began rising substantially in the early 90s,
reaching 5,000 by the end of 1995 and 7,000 by early 1997 and 9,000 in the spring of
1998. The all-time record high of 11,722.98 came on January 14, 2000. But in recent
months the prices of many companies’ stocks have fallen sharply; the “Dow’s” February
8, 2000 close of 9,744.93 down about 17% from the all-time high set just two years ago.
Dow Jones & Co. (which publishes the Wall Street Journal and Barron’s) also produces a
20-stock Transportation average (based on railroad, airline, and trucking firm stocks) and
a 15-stock Utilities average.
Prominent in the news in the last couple of years has been the National Association of
Securities Dealers Automated Quotation, or NASDAQ, index of “over the counter”
or “OTC” stocks (those not listed on the stock exchanges). Many of the NASDAQ
companies are newer high-tech or other relatively small corporations thought to have high
growth potential (although some, like Microsoft, are quite large). The NASDAQ hit its
all time high of 5,048.62 just two years ago on March 9, 2000. But NASDAQ stocks
have been hit especially hard in the recent downturn; the February 8, 2002 close of
1,818.73 is down a whopping 64% from that fairly recent all-time high. (Many investors
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have wanted to sell, and few have wanted to buy, some of these high-tech stocks as the
companies have failed to meet their expected financial successes, especially among
Internet companies whose revenues were largely based on advertising fees – which dried
up when other Internet firms cut back on their own promotional spending.)
Because the “Dow” is seen as representing the “blue chip” sector and the NASDAQ is
seen as representing the “high-growth” sector, these indexes tend to be the two that are
most widely reported in the daily media, especially since both hit all-time highs and then
fell dramatically over the last two years. (Those heavily invested in stocks can at least be
happy that both the DJIA and NASDAQ indexes have been somewhat higher recently
than they were a year ago).
Other stock market measures are the Standard & Poor’s 500 index, based on the stock
price movements of 500 large American firms selected for inclusion by S&P analysts;
the New York Stock Exchange Index, based on the stock prices of all NYSE-listed
corporations; the Value Line Composite Index of a broad range of NYSE, ASE, and
OTC Stocks; and the Wilshire 5000 index, based on the stock prices for “5,000” (actually
more than 6,500) publicly-traded U.S. corporations. There are also indexes based on
specific market sectors [technology] and on international stocks (like the Dow Jones
World Index or Salomon Brothers-Russell Global Equity Index), along with the Russell
2000 index of “small” company stocks (the Russell 3000 includes the 3,000 largest US
corporations; the Russell 2000 remains after the Russell 1000 – the largest 1,000 US
corporations – is removed from the Russell 3000 list).
[A small capitalization, or “small-cap,” company is generally said to be one whose
“market capitalization” – the total value of all the shares of stock held by investors
inside or outside the company – is less than $1.5 billion. A “mid-cap” company is
generally said to be one whose outstanding common stock has a total value between
$1.5 billion and $8 billion. Companies smaller than those in the “small-cap” category
are sometimes referred to as “micro-cap.” The designation as micro- vs. small- vs. mid-
vs. large-cap can differ across publications or analysts; there is no legal or other official
definition. These classifications exist simply to help quickly explain a portfolio’s
composition, or an investment manager’s goals or strategy. Note that some mutual funds
follow a “multi-cap” strategy of including stocks of companies from various size ranges.]
Earnings per Share (EPS): The amount of earnings available to each ownership unit,
computed as total earnings (for the most recent year) divided by the number of shares of
common stock that exist (or that might be expected to come into existence as company
managers exercise their rights to buy shares as part of their compensation packages). EPS
forms the basis for some popular “rules of thumb” computed by stock market analysts.
Trefzger/Investment Basics/2-10-02 10
Bull and Bear Markets: A bull market is said to be one in which prices have been rising
(especially if the rise has been 20% or more from an earlier low), and/or there is general
belief that they will (continue to) rise. A bear market is said to be the opposite, in which
stock prices have been falling (especially if the drop has been 20% or more from an
earlier high), and/or are expected to (continue to) fall. The names come, as I understand
it, from merry old England. First, speculators were referred to as “bears,” because they
would “sell the skin of the bear before the bear had been trapped.” Furthermore, the
politically incorrect “sports” of “bull-baiting” and “bear-baiting” (setting attack dogs
loose on bulls or bears chained to trees) caused bulls and bears to be seen as metaphorical
counterparts to one another.
Don’t forget, though, that for every seller there has to be a buyer. So terms like “bullish”
or “bearish” that some commentators use to characterize market attitudes can describe the
general views of certain groups of people, but it is difficult to see how they can describe
the entire marketplace, because no one would ever buy a stock unless he or she thought it
was a good buy at the prevailing price. So the buyers who buy when prices have fallen
must be of the opinion that the prices will soon be rising again.
Buying on Margin: Purchasing securities with borrowed money. By borrowing part
of the money for a stock purchase (with the help of a broker), the investor can buy more
shares than she could if she used only her own funds. Since current Federal Reserve
regulations permit investors to borrow up to half of the purchase price, you can buy twice
as many shares as would be possible otherwise. For example, if you have $1,000 to
invest you can buy 20 shares of a $50 stock with your own money. But if you borrow
$1,000 in addition to your own $1,000, you can buy 40 shares of that $50 stock. Then if
that stock’s price rises by $5 per share, your gain is 40 x $5 = $200 rather than just 20 x
$5 = $100.
Unfortunately, if the price falls by $5 per share you are losing $200 instead of only $100.
So buying on margin, like any form of financial leverage (the use of borrowed money),
is said to be a “two-edged sword.” In fact, if shares purchased with borrowed money
fell substantially in price, the broker would make a margin call to notify the investor
that more cash would have to be paid into the brokerage account to replace the eroded
collateral value (brokers keep possession of shares bought on margin to secure the loan),
or else the shares would be sold to satisfy the debt. So there are substantial risks, and the
margin buyer also must pay interest on the loan.
Short Selling: Selling shares of stock borrowed from a broker (to which the broker has
access because someone bought those shares on margin) in the expectation that they will
fall in price. Recall that your goal, as an investor, is to buy when the price is low and sell
when the price is high. What if you think that the price of a particular corporation’s stock
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is currently at a high point, and that it is poised to fall? If you currently owned some
shares, you would sell them. But if you do not own that stock, you can still sell it while
the price is (in your estimation) high, by borrowing the desired number of shares, selling
them, and then later buying that same number of shares at a lower price to replace what
you have borrowed and sold. If your price forecast is correct, you will have bought low
and sold high, but in the opposite order.
Like margin buying, short selling is a tricky and risky undertaking, probably not well-
suited to beginning investors. One problem is that, between the date when you sell the
borrowed shares and the date when you replace them, you must provide cash to pay
dividends to the investor from whom the shares were borrowed (since the investor who
bought the borrowed shares from you will receive the dividends actually paid by the
corporation). Furthermore, you might guess incorrectly; if the stock actually rises in price
rather than falling, you must eventually pay a higher price to buy shares to replace those
you borrowed (you would have sold low, bought high, and possibly paid out a lot of cash
to replace the missing dividends in the meantime).
Tombstone Ad: An announcement in a financial publication showing that a corporation
has issued new shares of stock, and listing the names of all the investment banking firms
that are involved as underwriters. (The layout resembles the listing of names on a
memorial monument.) Recall that the underwriter purchases the stock from the
corporation so that the corporation has immediate access to the needed money, and
then the underwriter takes the responsibility for (and accepts all of the risks connected
with) selling the shares to the investing public. So a good skeptic asks: when a broker
recommends a stock, does she do so because she truly believes the stock is attractively
priced, or does her enthusiasm reflect the fact that her firm is an underwriter currently
holding a lot of that stock, and that her job is to sell some of it to you? (Recall the
controversies in late 2001: media star stock analysts Mary Meeker and Henry Blodgett
had been recommending the poorly performing stocks of battered high-tech companies
to their firms’ brokerage clients, while at the same time their huge paychecks were
dependent on the underwriting business that their firms’ investment banking divisions
were doing with those same battered high-tech companies.)
Balance Sheet: A document that shows what a business owns, and who provided the
money to pay for it. Balance Sheets and Income Statements are known generically as
Income Statement: A document that shows how much money a business has collected
(revenue) during the most recent year, how much was spent in producing that revenue,
and the resulting amount of earnings (also called profit or net income). A corporation’s
earnings, which belong to the common stockholders, can be paid out as cash dividends
Trefzger/Investment Basics/2-10-02 12
to those stockholders or kept by the company (retained earnings) to pay for new
computers, machines, inventory, or other needed items.
Business managers retain earnings to help make their firms bigger/stronger without
having to either borrow more money or bring in additional stockholders. Their hope
is that the bigger, stronger nature of the firm will result in a higher stock price (capital
gains) in the short run and bigger dividend payments to the common stockholders over
the longer run. We usually think of growth stocks as stocks of firms that are getting
larger and selling a lot of their products or services, and therefore paying their common
stockholders little in dividends currently because they have to retain all their earnings to
pay for their growing inventory and equipment needs. (Some stockholders prefer to see
managers retain earnings instead of paying dividends, on which income tax must be paid
in the year when received.)
Let’s consider a simple example of a Balance Sheet and Income Statement for a
As of December 31, 2001
Assets (What the Firm Owns)
Cash and Short-Term Investments $ 400,000
Accounts Receivable 600,000
Land, Buildings, and Equipment 5,000,000
Total Assets $7,000,000
Claims (Who Paid for the Assets)
Bills Owed $ 300,000
Loans from Banks (Short-term) 700,000
Loans from Bondholders (Long-term) 2,000,000
Amounts Paid Out-of-Pocket by Owners
(500,000 shares @ $5.00 per share) 2,500,000
Total Amounts Retained on Behalf of Owners
Since Company was Founded 1,500,000
Total Claims $7,000,000
Points to Note:
1) The Balance Sheet “balances” in that total assets equal total claims. In other words,
everything the company owns was paid for by someone, who in turn has a right to be
repaid by receiving promised payments (lenders) or sharing in the company’s earnings
Trefzger/Investment Basics/2-10-02 13
2) We might view the Balance Sheet as an attempt to show how much money the owners
would get to keep if they sold all the firm’s assets and used the proceeds to pay off all
the firm’s debts. We might infer that this difference should represent the firm’s value
to a potential buyer. But the resulting number is a highly imperfect measure of the
firm’s value, because the amounts shown are generally based on the historical
amounts that were involved in the original transactions (“book values”) rather than
current market values. We should also note that the price a buyer pays for an ongoing
business is typically greater than the simple value of the asset base; the price should
reflect that business’s ability to generate future earnings.
3) On a book value basis, the firm is worth the $7,000,000 in assets minus the
$3,000,000 owed (“liabilities”) to parties other than the owners, or $4,000,000. But
again, this measure is highly imperfect.
For the Fiscal Year Ended December 31, 2001
Total Sales Revenue $10,000,000
Minus: Cost of Producing Goods 7,000,000
Equals: Operating Earnings 3,000,000
Minus: Interest Paid to Lenders 1,333,333
Equals: Pretax Earnings 1,666,667
Minus: Federal and State Income Taxes 666,667
Equals: Earnings to Shareholders (“Net Income”) $ 1,000,000
Disposition of Net Income:
Dividends Paid $ 600,000
Earnings Retained $ 400,000
Earnings per Share ($1,000,000/500,000 shares) $2.00
Point to Note: We might view the Income Statement as an attempt to show how much
cash became available for the owners during the time period measured. Cash (dividends)
is the financial return that investors want to receive (now, or in the future through the
stronger foundation built by retaining earnings). But the number shown as earnings is
a highly imperfect measure of the amount of cash available, because accountants use
“accrual” figures that may reflect some cash actually paid or received in a time period
other than the one that the Income Statement covers.
Numbers from the Balance Sheet and Income Statement are the basis for two measures
that stock market investors sometimes use:
Trefzger/Investment Basics/2-10-02 14
1) Price/Book Value per Share: The idea is to divide the stock’s current market price
by the book value per share, and to view favorably an answer less than 1. From the
Balance Sheet shown above, the book value per share is the $4,000,000 book value of the
owners’ claim divided by the 500,000 existing shares, or $8.00 per share. If the stock
price is only $7.00 per share, then the Price/Book Value per Share ratio is $7/$8 = .875.
An analyst might argue that you could pay $7 to control assets that are worth $8 net of
amounts owed to lenders (paying 87½¢ on the dollar). But there are two serious
problems with using this measure as a means of making investment decisions. First, as
discussed earlier, the historical values shown on the Balance Sheet may have little to do
with current economic realities. Second, investors are believed to buy stock based on the
company’s potential to earn future income, not based on the price at which the assets
could be sold piecemeal.
2) Price/Earnings per Share (“P/E”): The idea is to divide the stock’s current market
price by the earnings per share shown on the most recent income statement. The logic
is that one recent year’s earnings might give us a clue about future earnings, and that we
can compare that earnings figure to the stock price. The answer is not one that can be
interpreted in any specific way; however, a number that is low compared to general
historical average P/Es (maybe less than 15) is viewed by some as a signal that the stock
is a bargain: pay a small price to get big future cash payments. A number that is high
compared to general historical average P/Es (maybe about 30, which is where the market
was on average at year 2000’s high point) is viewed by some as a signal that the stock
is overpriced: pay a high price to get small future cash payments. From the Income
Statement shown above, the earnings per share is $2.00. If the stock price is $25.00 per
share, then the P/E ratio is $25/$2 = 12.5.
But while the P/E ratio is a more defensible (and more widely used) measure than is
Price/Book Value, there are serious problems with the P/E ratio as well. One is that
earnings shown on the Income Statement is such an imperfect measure of cash available
to the owners. Another is that a recent year of earnings may not reflect what is likely to
happen in the future. In fact, while some view a low [high] P/E ratio as evidence of a
bargain [excessive] price, others view it as evidence that smart investors are avoiding
[seeking out] the stock because they feel that earnings will fall [rise] in the future.
Stock Split/Stock Dividend: The creation of new shares of stock, not through the
issuing corporation’s collection of new money from new investors to purchase new
assets, but rather when the issuing company simply declares that each stock holder now
owns, for example, 200 shares instead of 100 (in the case of a two-for-one split) or 110
shares instead of 100 (in the case of a 10% stock dividend). Those who do not like the
idea of stock splits/dividends view them as mere “paper shuffling” exercises with no true
economic value; they liken the situation to that of simply giving someone five $1 bills in
Trefzger/Investment Basics/2-10-02 15
place of a $5 bill. After all, if the stockholder had held 100 shares that represented a 1%
ownership stake in the company, telling her that she now has 200 shares representing the
same 1% ownership stake in an unchanged company provides no economic benefit.
Defenders of stock splits tend to feel there is an “optimal trading range” for common
stock, such that if the price per share gets too high the stock can not be bought by small
investors in the traditional 100-share “round lots.” For example, let’s say that XYZ
Company’s stock rises over time to $200 per share; an investor now needs $20,000 to buy
a round lot – too much for many small buyers to devote to one stock. But a four-for-one
split, the argument goes, would bring the value initially down to $50 per share, or a more
affordable $5,000 for a round lot. “Mom and pop” investors would start buying it, so we
are told, and the newfound buying activity would drive the price up, say, to $51 per share.
Now someone who had held 100 of the $200 shares ($20,000 total) owns 400 of the $51
shares ($20,400 total); value has been created!!
Not so fast, say the cynics. If the price had been too high for small investors to buy
directly, they could simply have sent their money to mutual funds that invest in the type
of company in question. Cynics ask whether the desire to make the stock affordable
to small investors reflects not some quest for corporate democracy on the part of the
company’s managers, but rather a desire to keep the stock widely owned among more
passive “mom and pop” types, so that a small group of motivated mutual fund managers
does not gain the voting power to take decisive action against ineffective managers.
Those who defend stock dividends tout them as a way for the company’s managers to
reward shareholders without having to part with precious corporate cash. They especially
like the idea if the greater number of shares is accompanied by a sustaining of the original
level of cash dividends per share (instead of getting a 50¢ dividend on each of 100 shares
= $50, the investor now gets 50¢ on each of 110 shares = $55). But the cynic asks: why
not simply raise the cash dividend to 55¢ per share if the company can afford to part with
the extra cash? Defenders’ responses may focus on “flexibility” issues, like giving the
company the ability to “repurchase” some shares in the marketplace if it has extra cash at
some point without its having to commit to paying a higher cash dividend per share. But
the cynic sees the whole process, generally, as pointless paper shuffling.
Some Closing Thoughts: Good Sources of Information
There are more sources of information on the stock market, and on investing in general,
than anyone could ever hope to read. Some is produced and distributed with the goal of
getting you to buy particular investment products, and some media commentators have
direct or indirect financial stakes in the products they recommend. Much of the available
information is good, but much is not, so proceed carefully.
Trefzger/Investment Basics/2-10-02 16
Among the truly good sources of information on investing, some are timely and some are
timeless. In other words, while it is useful to read or hear the views of people who are
close to the market’s current activity, there are some fundamental concepts that, once
learned, will help to shape your investment thinking and actions for the rest of your life.
My listing of a few personal favorites is not intended to reflect badly on other sources you
may have used or considered.
The Only Investment Guide You’ll Ever Need, by Andrew Tobias. This very
successful book has gone through various revisions/enhancements over the years,
with titles such as Still The Only Investment Guide You’ll Ever Need and The Only
Other Investment Guide You’ll Ever Need. Look for the most recent edition available
(paperback), in which the author has combined his most important ideas from all the
earlier versions. Readable, practical, very accessible to the beginner. Tobias has
written financial articles for popular magazines, and he has served as treasurer of the
Democratic National Committee – a Democrat with an interest in investing and the
financial markets (isn’t that supposed to be a contradiction in terms??).
A Random Walk Down Wall Street, by Burton Malkiel. Earlier editions would
probably be all right, but the most recent (7th?) edition should be available in
paperback for about $16. Malkiel is a noted economist and investment theorist
(professor at Princeton). The book is a fairly readable treatment, designed for the
non-specialist, of modern investment theory. Accessible to the serious beginner.
Graham and Dodd’s Security Analysis, by Sidney Cottle et al. The serious investor’s
guide to analyzing individual corporations’ stocks (so it’s about fundamental analysis,
in which efficient market adherents do not place much belief). First published in the
1930s by Benjamin Graham (seen by many as the father of investment analysis), it has
undergone so many revisions that the original authors are long dead. Heavy reading.
The Wall Street Journal, especially the “Getting Going” column that has become a
mainstay on the front page of the back section of each week’s Tuesday edition.
Forbes magazine. Timely commentary on a range of investment topics, with a range
of viewpoints. Good skeptics will usually find something to agree with.
Kiplinger’s Personal Finance magazine. Thorough, informative, very accessible to
the beginner. Much of its focus has come to be on covering mutual funds, as is also
true of Kiplinger’s competitors, Money and Smart Money magazines.
The foregoing material has been written and organized by the author in connection with presentations to various
Central Illinois investor groups. These groups included the Senior Professionals and students participating in Unity
Week at Illinois State University, the Girls Just Wanna Have Funds investment club at Country Companies Insurance
in Bloomington, Y’s Investment Club in Bloomington, and the WOWPIC investment club in Peoria.
Trefzger/Investment Basics/2-10-02 17
Final Comments: Four of my Favorite Financial Observations
The following are four of the most useful observations I have ever read or heard anyone
offer regarding the financial marketplace. All four made such an impact on my thinking
that I did not bother to write down the original citations, knowing that I would remember
the ideas. Of course, that means I can not give the observers’ precise words or tell where
you can find the actual quotes (Doherty’s observation comes from a class I took when he
taught in the Midwest many years ago). Please accept the “quotes” as paraphrasing of the
original words, while recognizing for their splendid insights those to whom the ideas are
attributed. Explanations following each italicized “quote” are my own.
First – From humorist Dave Barry: Q: How much life insurance do I need? A: That
depends on the age, lifestyle, and number of dependents of your life insurance agent.
When your agent is young and has few responsibilities, you can get by with a small
policy. But as he gets older and his financial needs increase, you will have to buy more
expensive coverage. See your agent for details.
The idea being offered in Barry’s tongue-in-cheek way, of course, is not that life
insurance agents are especially troublesome (although some states’ attorneys general have
taken legal action in recent years against some large life insurers’ agents for fraudulent
sales practices). The point is that someone trying to sell you any type of financial (or
other?) product may be thinking more of his/her needs than of yours, so you must always
Second – From financial writer Andrew Tobias: Some of your best financial returns can
come from saving money on things you ordinarily buy.
Let’s say that you use 10 super-size boxes of laundry soap per year; the regular price is
$10, which is how much you normally pay. A store runs a special: 20% off the regular
price. You buy 10 boxes for $8 each. You now have $80 tied up for a year in soap, but
have saved $20 by making that commitment. So your one-year rate of return on the
$80 investment is $20/$80 = 25%. (Think of the dollar benefit of doing this on many of
the items you consume.) In fact, the return is better than 25%, because 1) if you would
otherwise buy one box every 5 weeks or so, you wouldn’t otherwise have the use of the
$80 for the whole year anyway, and 2) you don’t owe any income tax on that 25% return.
You aren’t likely to do anywhere near that well in the traditional investment marketplace,
where you also face much higher risks.
Yes, there are a few potential drawbacks: 1) it doesn’t work so well for perishable goods
(although there is nothing magical about a full year’s supply; we choose a year merely to
simplify our computation of an annualized rate of return in the example); 2) we have to
recognize the cost of storage (possible spillage or theft, added insurance costs, or just the
Trefzger/Investment Basics/2-10-02 18
inconvenience of it all), especially for bigger or more expensive items; and 3) there is
some risk (you’ll kick yourself if another store runs a 30% sale the following week, or if a
new product comes out that you like a lot better and you’re now stuck with three shelves
full of boxes of the old stuff). And if you spend considerable hours each week actively
looking for bargains, we must consider your returns net of opportunity costs on your time.
Third – From Professor Neil Doherty of the Wharton School at the University of Pennsyl-
vania: The chap on the news told me that the stock market was down because of “profit
taking.” How the bloody hell did he know that? Did he ask everyone in the world who
bought or sold stock yesterday why they did it, and if so, did they all tell him the truth?
The news report was, no doubt, based on the honest best guess of a local stock broker,
who had heard the “profit taking” reason given by a client or two. But to generalize from
that small amount of information is misleading, both with regard to the reason for a given
day’s trading activity and with regard to our ability to tell why specific things happen in
the market. (And what about the people on the other sides of those “profit-taking”
transactions; were they “loss accepting?”)
Fourth – From Nobel Prize-winning economist and Massachusetts Institute of
Technology Professor Paul Samuelson: All of history can be seen as one observation.
For example, some people take comfort in noting that the stock market has always
ultimately reached new highs after falling. But perhaps we would be on more solid
ground noting that we have merely seen one thing happen: a long series of events during
which stocks have repeatedly risen to new highs after falling. Would you confidently
predict that you will see Tom Hanks on a particular corner in downtown Chicago at noon
every day simply because you saw him there at noon once?
Or note that if you tossed a fair coin repeatedly, you would have about a 1 in 1,000
(actually 1 in 1,024) chance of flipping “heads” (or “tails”) ten times in a row. In a
different context, we could say that about 1 in 1,000 mutual fund managers has been
observed to provide investment returns better than the market average for ten years in a
row. Could chance/luck alone help to account for the perennial successes of a few top-
performing fund managers?
The historical angle is interesting from another viewpoint. For example, some people
were confidently paying prices reflecting unprecedentedly high P/E ratios a few years ago.
They had said that historical relationships had come to be unimportant in the modern
high-tech world. But then they further defended the high prices they paid by noting that,
historically, the market always reaches new highs. So which is it: does history matter, or
does it not?
Trefzger/Investment Basics/2-10-02 19
Question 1: At a garage sale, on a table of kitchen items, Alice spots an old Mason jar
that she recognizes as a collector’s piece worth $2,000. She hands a $1 bill to the man
conducting the sale, and he gives her two quarters in change. What did the antique
Mason jar cost Alice?
The deceptively simple answer, of course, is 50¢. But the 50¢ is actually pretty
inconsequential. More substantive is Alice’s cost of time and travel in getting to every
garage sale in town to locate such a rare bargain. But an even greater cost involves the
many years Alice has devoted to learning about antique jars so that she would know the
difference between a 50¢ junk piece and a $2,000 show piece.
Question 2: Because of his superb handyman skills, Bill buys a small apartment building.
He pays $100,000 for the property. During the first year, his rent receipts, net of
operating costs (which are quite low since he does almost all management and repair/
maintenance work himself) is $14,000. At the end of the first year, the property is still
worth exactly $100,000. What has been Bill’s percentage rate of return (pre-tax) on his
invested dollars during year 1?
The easy answer would seem to be $14,000 income ÷ $100,000 invested = a 14%
annualized, pre-tax rate of return. But what if Bill is at the property many hours each
week doing yard work, fixing leaky faucets, handling tenant problems, etc? Then the
$14,000 is clearly a return both on his investment and on his labor. Let’s say that during
the year he contributes 16 hours (average) per week x 52 weeks = 832 hours of labor. If
he could earn $10 per hour doing some other job during those hours, then we must look at
832 x $10 = $8,320 of the $14,000 as a return on his labor. The other $5,680 is a return
on his $100,000 investment: $5,680 ÷ $100,000 = 5.68%.
Question 3: Clara and Clyde invest $100,000 in a portfolio of stocks. During the first
year, their diligent analysis (reading the Wall Street Journal, Value Line, brokerage
house reports, on-line information; talking to their broker; watching CNBC every day)
seems to pay off: the value of the portfolio rises to $110,000, and they also receive $4,000
in dividends. What has been Clara and Clyde’s annualized rate of return (pre-tax) on
their invested dollars during the past year?
Again, the easy answer would seem to be ($10,000 capital gain + $4,000 dividends) =
$14,000 income ÷ $100,000 invested = a 14% annualized, pre-tax rate of return. But,
again, we have to look at all the time the pair spends managing their portfolio. Again,
the $14,000 is clearly a return both on their investment and on their labor. Let’s say that
during the average week they spend, together, 16 hours absorbing written and broadcast
information on the market and the stocks they hold; 16 x 52 = 832 hours of labor over the
year. If they could earn $10 per hour doing some other job during those hours, then we
must again look at 832 x $10 = $8,320 of the $14,000 as a return on labor. The other
$5,680 is a return on the $100,000 invested: $5,680 ÷ $100,000 = 5.68%.
Trefzger/Investment Basics/2-10-02 20