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ADMS 3531 (17)
Chapter 3

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Department
Administrative Studies
Course
ADMS 3531
Professor
Dale Domian
Semester
Winter

Description
Chapter 3: The Investment Process 3.1 The Investment Policy Statement Objectives: Risk and Return - most investors are risk aversall other things the same, they dislike risk and want to expose themselves to the minimum risk level possible - first thing that must be assessed in evaluating the suitability of an investment strategy is risk tolerance - In formulating investment objectives, the individual must balance return objectives with risk tolerance. o Investors must think about risk and return. o Investors must think about how much risk they can handle. - Your risk tolerance is affected by o Your ability to take risk o Your willingness to take risk Investor Constraints (5 most important and common constraints)  Resources: - if you have no money, you cannot invest at all - an investor interested in actively trading on her own would probably need more like $5,000 to $50,000  Horizon: - investment horizon refers to the planned life of the investment - individuals frequently save for retirement, where investment horizon (depending on your age) can be very long - you might be saving to buy a house in the near future, implying a relatively short horizon -when thinking about the riskiness of an investment, one important consideration is when the moneybeill needed  Liquidity: - an asset with a high degree of liquidity is one that can be sold quickly without a significant price concession (such an asset is said to be liquid) - a good way to think about liquidity is to imagine buying an asset and then immediately reselling it - the less you would lose on this “round-trip” transaction”, the more liquid is the asset  Taxes: - when we talk about the return of an investment, what is really relevant is the aftertax return - as a result, taxes are a vital consideration - higher tax bracket investors will naturally seek investment strategies with favourable tax treatments - lower tax bracket (or tax-exempt) investors will focus more on pretax returns - with a tax break being enormous (such as, retirement savings account) the amount you can invest each year in these accounts is strictly LIMITED and there are a lot of rules regarding when you can withdraw the money and it is important to pay careful attention to them - taxes impact almost every step of the investment process (from the type of account you choose to the nature and length of the investments themselves)  Unique Circumstances: - number of dependents and their needs will vary from investor to investor, and the need to provide for dependents will be an important constraint - some investors want to invest only in companies whose products and activities they consider to be socially or politically suitable, and some investors want to invest primarily in their own community or state  Resources. What is the minimum sum needed? What are the associated costs?  Horizon. When do you need the money?  Liquidity. How high is the possibility that you need to sell the asset quickly?  Taxes. Which tax bracket are you in?  Special circumstances. Does your company provide any incentive? What are your regulatory and legal restrictions? Strategies and Policies (4 key areas investors need to address when they devise their investment strategy)  Investment Management: - often investors partially manage their investments themselves and partially use professional managers - you should consider the value of your time - for some strategies, the costs of doing it yourself can exceed those of hiring someone even after considering fees simply because of the higher commissions and other fees that individual investors frequently pay  Market Timing: - whether you will try to buy and sell in anticipation of future direction of the overall market - you might move money into the stock market when you thought it was going to rise, and move money out when you thought it was going to fall (this is called market timing)  Asset Allocation: - the distribution of investment funds among broad classes of assets - important asset allocation decision for many investors is how much to invest in common stocks and how much to invest in bonds - basic rule of thumb: split portfolio into 60 percent stocks and 40 percent bonds  Security Selection: - selection of specific securities within a particular class - security selection is a much more micro-level activity because the focus is on individual securities  Investment management: Should you manage your investments yourself?  Market timing: Should you try to buy and sell in anticipation of the future direction of the market?  Asset allocation: How should you distribute your investment funds across the different classes of assets?  Security selection: Within each class, which specific securities should you buy? 3.2 Investment Professionals Choosing a Broker/Advisor  What do you do after carefully crafting your Investment Policy Statement (IPS)?  If so, you need to choose the type of brokerage account and your broker/advisor from: 1. full-service brokers 2. discount brokers 3. deep-discount brokers  These three groups can be distinguished by the level of service provided, as well as the level of commissions charged. - they are divided into three groups: full-service brokers, discount brokers, and deep-discount brokers - deep-discount broker: the only services provided are account maintenance and order execution (buying and selling), you deal with them over the phone or using a Web browser - full-service broker: provide investment advice regarding the types of securities and investment strategies that might be appropriate for you to consider (or avoid), the larger broker firms do extensive research on individual companies and securities and maintain lists of recommended (and not recommended) securities, they maintain offices throughout the country, so depending on where you live, you can actually stop in and speak to the person assigned to your account (they will even manage your account for you if you wish) - rather than charging commissions on every transaction, the investment advisor charges an annual fee, say 1-2 percent, based on the balance on the account (this fee covers all services associated with advice and trading) - advisory-based relationship covers all services associated with advice and trading and it brings potential benefits to the client and advisor - without commission, the advisor has little incentive to trade an account actively - discount broker: fall somewhere between the two cases we have discussed so far – offering more investment counselling than the deep-discounters and lower commissions than the full-service brokers - often investors begin with a full-service broker, and then, as they gain experience and confidence, move on to a discount broker Online Brokers - most important recent change in the brokerage industry is the rapid growth of online brokers (also known as e-brokers or cyberbrokers) - you place buy and sell orders over the Internet using a Web browser - Stock-Trak is an example of a portfolio simulation - before 1995, online accounts did not exist - by 2000, many millions of investors were buying and selling securities online Canadian Investor Protection Fund - when you deposit money in a bank, your account is normally protected (up to $100,000) by the Canadian Deposit Insurance Corporation (CDIC) - brokerage firms, even though they are often called investment banks, cannot offer CDIC coverage - most brokerage firms belong to the Canadian Investor Protection Fund (CIPF) which was created in 1969 - the CIPF insures your account for up to $1,000,000 for losses of securities, commodity and future contracts, segregated insurance funds and cash - CIPF is not a government agency; it is a private insurance fund supported by the securities industry - the Securities Investor Protection Corporation (SIPC) provides the similar coverage for brokerage firms operating in the United States - the SIPC insures your brokerage account for up to $500,000 in cash and securities, with a $250,000 cash maximum - CDIC coverage: value of whatever you deposit into a bank is fully guaranteed and you will not lose a cent under any circumstances - CIPF coverage: insures only that you will receive whatever cash and securities were held for you by your broker in the event of fraud or other failure (the value of securities is not guaranteed – you can lose everything in an CIPF-covered account if the value of your securities falls to zero) (c) Buy 100 Shares of Tim Hortons at $53 per share (e) $4,650 Cash in Account $5,300 Stock In Account (d) Pay Commission, Say $50 (b) Deposit $10,000 into account (a) Open a brokerage or trading account Broker-Customer Relations - any advice you receive is NOT guaranteed - buy and sell recommendations carry the explicit warning that you rely on them at your own risk - your broker works as your agent and has a legal duty to act in your best interest - you are responsible for your account statements 3.3 Types of Accounts Cash Account - a brokerage account in which all transactions are made on a strictly cash basis - securities can be purchased to the extent that sufficient cash is available in the account Margin Accounts - a brokerage account in which, subject to limits, securities can be bought and sold on credit - using money loaned to you by your broker – such a purchase is called a margin purchase - the interest rate you pay on the money you borrow is based on the broker’s call money rate (the rate the broker pays to borrow the money) - you pay some amount over the call money rate called the spread (the exact spread depends on your broker and the size of the loan) - example: suppose the call money rate has been hovering around 7% and if a brokerage firm charges a 2.5% spread above this rate, then you would pay a total of about 9.5%) - when you purchase securities on credit, some of the money is yours and the rest is borrowed (the amount that is yours is called the margin) Initial Margin - when you first purchase securities on credit, there is a minimum margin that you must supply (this percentage is called the initial margin) - there is little initial margin requirement for government bonds - margin is not allowed at all on certain other types of securities Example of Initial Margin: Suppose you have $3,000 in cash in a trading account with a 50 percent initial margin requirement. What is the largest order you can place (ignoring commissions)? If the initial margin were 60 percent, how would your answer change? $3,000 = 0.50 x Total Order Total Order = $3,000 / .50 Total Order = $6,000 $3,000 = 0.60 x Total Order Total Order = $3,000 / .60 Total Order = $5,000 Maintenance Margin - brokerage firms and exchanges generally have a maintenance margin requirement  minimum margin that must be present at all times in a margin account - for instance, the New York Stock Exchange (NYSE) requires a minimum 25 percent maintenance margin (this amount is the minimum margin required at all times after the purchase) - the maintenance margin set by your broker is sometimes called the “house” margin requirement - for low-priced and very volatile stocks, the house margin can be as high as 100 percent, meaning no margin at all - a typical maintenance margin would be 30 percent (if your margin falls below 30 percent, you may be subject to a margin call) - the margin call is a demand by your broker to add to your
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