Committing capital with the expectation of profit. The expected profit may be in the form of dividends, interest, or capital appreciation. Speculation refers to an attempt to make profit from short-term changes in the price of an asset.
Investments are classified in financial terms as fixed-income and equity investments. Fixed-income investments include bonds, real estate mortgages, and preferred stock. Equity investments include common stock and real estate. The major classifications of stocks include industrial, financial, public utility, and railroad stocks. The major classes of bonds are U.S. government, state and municipal government, and corporate obligations.
In a broad sense, the investment decision takes into consideration the investor's situation and the characteristics of possible investments. The investor's situation typically involves such matters as their expectations, motives, income, cash requirements, capital, time horizon (short, intermediate, or long-term), safety and other considerations as well as from a proper evaluation of the risks they are willing to assume.
The basic matters to consider when evaluating different investments are yield, risk, duration, liquidity, and tax impact. Yield is required to compensate the investor for the impact of inflation and for risk-taking. The total yield on an investment is the increase in the value of the investment, usually stated as a percent of invested capital per year. When inflation is taken into consideration, the yield investment will be worth less in real dollars than when it was made, taking into consideration the investment's cumulative yields. Beta is a measure of the risk of an individual stock relative to the stock market as a whole. Risks associated with bonds are typically based on the probability of default on principal or interest. As a general rule, the higher the yield, the higher the risk, and vice versa. Risk can sometimes be avoided through diversification of investments. Risks can also be avoided in some situations by taking into consideration the duration of the investment. Certain stocks are extremely risky over a period of time shorter than the economic cycle which is considered to be three to five years and less risky in the long run. Liquidity of an investment refers to whether the investor can withdraw the invested funds on demand. The degree of required liquidity will affect the type of investment an investor should consider.
Investment instruments are usually either equity or debt, or a combination thereof. Equity, or ownership, entitles the investor to a share in the profit and capital appreciation. Debt instruments provide a return in the form of interest and capital appreciation. Preferred stock is legally an equity interest but has some of the characteristics of a bond with an infinite term. convertible bonds, convertible preferred stock, and participating preferred stock also contain elements of equity and debt.
Characteristics of various types of investments are summarized in the appended exhibit.
The purpose of bond analysis is to evaluate the ability of the debtor to pay interest and principal as they fall due. The purpose of common stock analysis is to determine the probable future value of a share of stock. Many factors are involved in determining the value of common stock, especially earnings per share and the price/earnings ratio at which the shares sell. Factors affecting investment evaluations include the trend of earning per share, the quality of reported earnings and corporate assets, dividend policy, demand for the stock, and the quality and performance of management. Major factors affecting the quality of earnings include depreciation practices, research and development expenditures, and inventory policies.
A glossary of major terms related to securities trading on exchanges is presented here.
Glossary of Securities Trading on Exchanges
Account: Record of client's transactions and credit/debit balances of cash and/or securities with a firm.
Arbitrage: The simultaneous purchase and sale of the same or equivalent money, commodity, or security, to take advantage of a price discrepancy. Place arbitrage attempts to take advantage of price discrepancies in different markets (for example, New York and London). Time arbitrage attempts to take advantage of price discrepancies between intermediate delivery or spot prices and future delivery or future quotations. Kind arbitrage seeks to take advantage of discrepancies in price between securities and other instruments that will become equivalent, such as convertible securities or split-up shares.
Asked price: Lowest price at which a dealer is willing to sell a security.
Basis point: .01% of yield on a fixed-income security. For example, if a bond yield to maturity changed from 9.10 to 10.45, there was a 130 basis points change.
Bid: Price at which someone is willing to purchase a security.
Block trading: Most of the shares traded on exchanges and over the counter are for large institutions (insurance companies, financial institutions, corporations) instead of for individuals. Such transactions, which involve more than 10,000 shares are referred to as block trades. If the firm handling the block trade is a member of the NYSE or Amex, the trade must "cross" on the floor of the exchange; the specialist collects a commission for the block and processes the trade through the exchange's computer system so that it appears on the tape and electronic ticker. Non-members can also trade "off the floor." Such off-floor trading of listed securities is referred to as the "third market" as distinct from the primary and secondary markets.
Blue-chip stocks: Common stock representing ownership of a major company with a long history of profitability and constant or increasing dividends. Blue-chip stocks are considered to be financially strong and capable of surviving severe economic downturns without significantly affecting their dominant position in the industry, profitability, or dividend-paying ability.
Charting: A practice of graphically presenting stock price indexes or individual stock prices to present a picture of price behavior over a period of time. Charting is used primarily to provide information about price trends and for forecasting.
Clearing: The settlement of security transactions. The clearing process offsets transactions so that the actual delivery of securities and money can be reduced. The Stock Clearing Corporation is organized to conduct the clearing process for the New York Stock Exchange. Transactions in stocks, rights, and warrants are cleared through the corporation. Odd lots and bonds are delivered by the Central Delivery Department.
Cyclical stocks: Stocks of corporations whose earnings fluctuate with the business cycle. Such companies have relatively low earnings per share during periods of recession and sharply increasing earnings during the recovery phase of the business cycle. Cyclical stocks are generally considered to include basic manufacEagle Tradersg industries, such as machinery and automobile manufacEagle Tradersg.
Dollar averaging: An investment strategy in which an investor purchases a fixed dollar amount of a particular common stock periodically. The investor hopes to accumulate a large number of shares when the price of the stock is low and a smaller number of shares when the price is high. Hopefully, the average price for all the shares will be substantially lower than the average price the investor would pay if he purchased a constant number of shares periodically.
Dow Jones averages: Market indicators published by the financial publishing house of Dow Jones & Co. Stock averages are computed for 30 industrial, 20 rails, and 15 utility common stocks, and a composite of the three groups. All stocks included in the averages are listed on the New York Stock Exchange. The averages are widely issued to reflect the trend of common stock prices over short or long periods of time.
Dow theory: An interpretation of the primary market trend which holds that there is no primary market trend (upward or downward for a year or more) unless there is simultaneous correlation between the movement of the Dow industrial, transportation, and utility averages.
Efficient market : A market in which it is assumed that all known information about a security is fully reflected in its price (that is, a price-efficient market). In an efficient market, mispriced securities do not exist. The market price of a security equals its fair intrinsic value. The investor trades only because he has excess cash, needs cash, or wants to attain a tax advantage.
Ex-dividend: A stock is purchased ex-dividend when the purchaser acquires the shares without the right to receive a recently declared dividend. An investor who purchases a share of stock on or after the ex-dividend date is four days prior to the date of record. The date of record is a date established when dividends are declared and is used to obtain a record of all stockholders of record as of the record date, which is usually several weeks prior to the payment date. A transfer of stock ownership prior to the ex-dividend date is said to be "cum dividends" or "dividends on" because the new owner of the shares will receive the dividend payment.
Form 10-K: A report filed annually with the Securities and Exchange Commission by a company that issues a separate annual report to shareholders. The company must report the following information in the report: financial statements, supplementary financial information, selected financial data for five years, management's discussion and analysis of financial condition and results of operations, market for the registrant's common stock and related security holder matters, a brief description of the business of the company and its subsidiaries, information for three years relating to industry segments, classes of similar products or services, foreign and domestic operations and export sales, identity of company's directors and officers, their principal occupation or employment, the name and financial business of their employer, and an offer in the annual report or proxy statement to provide without charge a copy of the Form 10-K and the name and address of the person to write to for this material.
Growth stocks: Stocks of corporations whose earnings have demonstrated rapid growth in comparison with the economy and which are expected to grow at above-average rates in the future.
Income stocks: Stocks of corporations with relatively constant earnings and dividends along with a high dividend yield in comparison with other stocks. Stocks of utility companies are often considered income stocks.
Junk bonds: Speculative bonds with a credit rating of BB or lower; such bonds usually have a high risk and high yield.
Margin trading: In margin transactions, the investor purchases securities and pays only a percentage of their cost; the balance is paid by the broker and is treated as a loan to the investor. For example, an investor purchases on margin 100 shares of stock at a price of 90. The investor might be asked to maintain a 60% margin - that is, he must pay 60% of the cost, or $5,400. This amount is his equity in the stock. The broker pays the remaining $3,600 as a loan to the investor, keeping the stock as collateral. The investor is thus able to purchase stock worth $9,000 while putting down only $5,400 of his own funds. The broker charges a commission on the full $9,000 purchase price, and also collects monthly interest on the loan. The investor expects the price of the stock to rise. Buying stock on the margin provides the investor with considerable leverage.
Odd-lot trading: Buying or selling in other than the established unit or round lot. In an odd-lot transaction, one-eighth of a point is added to (or deducted from) the price of each share purchased (or sold).
Options: Privileges acquired to buy or sell a security at a specified price within a specified period of time. Options include puts, calls, straddles, spreads, straps, and strips. A put is a contract giving the holder the privilege to deliver a given number of shares of a specific stock to the maker within a certain time and at a certain price. The holder expects to make a profit from a decline in the stock. A call is a contract whereby the holder obtains the privilege of purchasing stock. The purchaser expects to profit from an increase in the price of the shares. Straddles and spreads are combinations of one put and one call. In a straddle, the put and call are at the market when the options are written. When prices are points below the market for the put and above the market for a call, the results is a spread. A strap is a combination of two calls with one put; a strip is two puts with one call. The option price is at the market when the options are written. Put and call brokers publish lists of prices on options from time to time.
Orders: An order describes the terms and conditions relating to the execution of an order by a broker for a customer. Market orders to buy and sell at the market are the major type of orders used in securities trading. Limit orders are orders placed by customers to place a limit on the order as to price. A limit buying order must be executed at the limit price or less. A selling order limited to a specific price must be executed at that price or more. Day orders are automatically cancelled if not executed on the same day the order is placed. Open, or GTC (good till canceled), orders are good until executed or specifically cancelled by the customer. Stop-loss orders can be placed to limit losses. Stop-loss orders become market orders when the price of the stock reaches a specified quotation.
Over-the-counter markets: The over-the-counter markets are composed of security trading outside organized securities exchanges. These markets bring buyers and sellers together and increase the marketability for the large number of securities not traded on the organized exchanges. Unlisted stocks, government, municipal, and corporate bonds, and new issues are usually traded in the over-the-counter markets. Dealers in this market typically communicate by telephone with other dealers when negotiating (versus auctioning) transactions. the National Quotation Bureau, Inc. collects quotations and distributes a list to subscribers - pink stock sheets and yellow bond sheets divided geographically, Easter, Central, and Pacific.
Point: Market prices are listed in points. A point is equal to a market price of $1 per share. Listings normally are given to the nearest one-eighth of a point.
Round lot: Trading on the New York Stock Exchange is done in standard numbers of shares, called round lots. A round lot is usually 100 shares or multiples thereof. For bonds, the standard unit is one $1,000 bond. Lots smaller than round lots are called odd lots.
Securities Exchange Act of 1934: An act designed to make available more reliable information to the public, to prevent and provide remedies for fraud, manipulations and other abuses in security trading, to ensure fair and orderly markets, to regulate the securities markets and brokers and dealers to see that just and equitable principles of trading are observed, to regulate the use of credit in securities trading, and to regulate trading by insiders.
Settlement: Settlement refers to when and how a transaction on the exchange must be settled. Except for specific agreements, every transaction must be settled. Except for specific agreements, every transaction must be settled by 12:30 p.m., delivery time, of the fourth following full business day. A cash settlement involves delivery of securities and payment of money on the same day.
Short selling: The practice of selling securities that are not owned by the seller. A short sale can occur where the seller does not possess the securities sold; a sale against the box occurs if the seller owns the securities sold but does not intend to deliver them at the time of the sale. A short seller expects the price of the security sold short to decline and to be able to buy back or cover the short sale at a lower price at a future date.
Stock purchase warrants: Instruments attached to other securities that entitle the holder to purchase shares of common stock at a specified price per share within a given period or for an indefinite time. Warrants can be issued separately or attached to other securities. Also called option warrants.
Transfer taxes: An excise tax levied by the State of New York on all transfers of beneficial ownership of securities within the state. The federal government also levies an excise tax based on the market value of stocks, rights, or warrants sold.
When-issued or when-distributed basis: New securities issues are traded on a when-issued basis before the delivery of the securities can be made.
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