Chapter Three
PARTICIPATING IN
THE MARKET
1
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Measures of Price Performance:
Market Indexes
Indexes and Averages




Dow Jones Averages
Standard & Poor Indexes
Value Line Average
Other Market Indexes
2
Buying and Selling in the Market


Cash or Margin Account
Long or Short?–That Is The Question
Types of Orders
Cost of Trading
Taxes and the 2003 Tax Act

Capital Gains and Dividends
3
MEASURES OF PRICE PERFORMANCE
COMPARE WITH MARKET INDEXES
Please click on the icon for more information on the indexes
TYPE OF PORTFOLIO
Professional pension fund
manager’s portfolio
Mutual fund specializing in
small OTC stocks
Portfolio of a small investor
(in small cap stocks)
RELEVANT INDEX
S&P 500 Stock Index
www.standardandpoors.com
Nasdaq
www.nasdaq.com
Value Line Average or
Russell 2000
www.russell.com
4
Index

Statistical indicator providing a
representation of the value of the
securities which constitute it. Indexes
often serve as barometers for a given
market or industry and benchmarks
against which financial or economic
performance is measured.
5
INDEXES AND AVERAGES

Dow Jones Averages
• www.dj.com

Standard & Poor’s Indexes
• www.standardpoors.com

Value Line Average
• www.valueline.com

Other Market Indexes
• www.nasdaq.com

National Association of Securities
6
Dow Jones Averages



Industrial (DJIA)
Transportation (DJTA)
Utilities (DJUA)
Averages are maintained and reviewed by
editors of The Wall Street Journal. For the
sake of continuity, composition changes are
rare, and generally occur only after corporate
acquisitions or other dramatic shifts in a
component's core business. When such an
event necessitates that one component be
replaced, the entire index is reviewed. As a
result, multiple component changes are often
implemented simultaneously
7
Dow Jones Averages - continued

There are no rules for component
selection, a stock typically is added only if
it has
• an excellent reputation
• demonstrates sustained growth
• is of interest to a large number of
investors
• accurately represents the sector(s)
covered by the average
8
DJIA continued



DJTA include only transportation stocks
DJUA include only utilities stocks
DJIA not limited to traditionally defined
industrial stocks
• Serves as a measure of the entire U.S.
market, covering such diverse industries as
 financial services
 technology
 retail
 entertainment
 consumer goods
9
Calculation of DJIA

Unique
• price weighted
• NOT market capitalization weighted

Component weightings affected only by changes in the
stocks' prices
NOT (in contrast with other indexes‘) weightings that are
affected by both price changes and changes in the
number of shares outstanding
Initially, their values were calculated by simply adding up
the component stocks' prices and dividing by the number
of components
Later, adjusting the divisor was initiated to smooth out
the effects of stock splits and other corporate actions
The current divisor values are as follows: DJIA
0.13561241, DJTA 0.22477839, and DJUA 1.5940823




10
DOW JONES INDUSTRIAL
AVERAGE - DJIA







The most popular index
30 large industrial companies
“blue-chip” index i.e. stocks of very high quality
Price-weighted average
Follow the general trend of the market
Comprise more than 25% of market value of the
3,000 firms listed on the NYSE
Bias toward high priced stocks
www.djindexes.com
11
Standard & Poor’s Indexes


S&P 500 – a measure of broad stock
market activity (about 75% of the total
value of the 3,000 firms listed on the
NYSE
Used by:
• professional money managers
• Security market researchers
12
S&P 400 MidCap Index

Composed of
• 400 middle-sized firms
 Firms with market values between
$1.2 billion and $9 billion versus S&P
500 which shows the performance of
large firms like Microsoft – stock
symbol MSFT, market value $300
billion in January 2004
13
Other S&P Indexes



S&P 600 SmallCap Index
• Companies smaller that MidCap
S&P 1500 combines
• S&P 500
• S&P 600 &
• S&P 400
S&P 100
• 100 blue-chip stocks
 For which CBOE has individual option
contracts
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The Complete List
100 Stocks in NAZDAQ-100
Please click on the following Hyperlink for the
complete list
NASDAQ-100 (the index itself)

The Index reflects Nasdaq's largest
growth companies across major industry
groups. All index components have a
minimum market capitalization of $500
million, and an average daily trading
volume of at least 100,000 shares
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The shadow of the Index

The Nasdaq 100 Index Tracking Stock
(symbol) QQQQ is an Exchange Traded
Fund which allows investors to
essentially invest in all of the stocks that
make up the Nasdaq 100 in a single
security
16
This graph shows how closely the
shadow QQQ follows the Nasdaq
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Application Example

Standard & Poor’s Indexes
• value-weighted indexes
 each company weighted by its total
market value as a percentage of the
total market value for all firms
Example – a value-weighted index comprising of
three firms A, B, and C the weighting is shown
on the next slide
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Application Example
Value-weighted Indexes
Stock
Shares
Price Total Market Value
Weighting
A
150
$10
$1,500
12.0%
B
200
$20
$4,000
32.0%
C
500
$14
$7,000
56.0%
$12,500
100.0%
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Value Line Average


1,700 companies from NYSE, AMEX, and
NASDAQ
Equal-weighted index
• Weighted equally
• Regardless of market price or total market value

Equal-weighting more closely conforms to the
portfolio of individual investors
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Other Market Indexes
New York Stock Exchange http://money.cnn.com/mark
ets/nyse/
The American Stock
http://www.amex.com/
Exchange
Wilshire 5000 Equity Index http://www.neatideas.com/
w5000.htm
Russell 3000
Index symbol: $RAZ.X
Russell 2000
Russell 1000
http://www.neatideas.com/r
2000.htm
Index symbol:
$RUXY or $RUI.X
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Other Countries
Every major country has an index that
represents its stock exchange. Here are some of
the more important indexes around the world:






FTSE 100 - United Kingdom
Hang Seng - Hong Kong
Nikkei - Japan
DAX – Germany (Frankfurt DAX)
TSX - Canada
CAC 40 France
22
Important Consideration of looking
at an INDEX

How much the index has changed over a
given period of time
•
•
•
•
•
•
•
Hours (intraday)
Day
Week
Month
Quarter
Semi-annual
Year(s)
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Bond Market Indicators

Not widely followed by
• Index or
• Average

Gauged by
• Interest-rate movements
Rising interest rates
Falling interest rates
falling bond prices
rising bond prices
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Other Categories of Bonds





Treasury Securities
• Treasury notes
• Treasury Bills
• Treasury Bonds
Corporate debt
Mortgaged-backed securities
Municipal Bonds
Eurobonds
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Mutual Fund Averages

Mutual funds
• Preferred choice of investment for many
investors in the U.S. & worldwide

Commitment to mutual funds
• Necessity of understanding the underlying


Stocks
Bonds
26
Buying and Selling in the Market

Using full service brokers, e.g.
• Merrill Lynch
• Salmon Smith Barney
• UBS Paine Webber

Broker must determine investors’ objective
•
•
•
•

Conservative – preservation of capital
Income
Growth plus income
Growth
Risk versus (expected) return
27
Buying and Selling in the Market continued


Using discount brokers
Using online brokers
•
•
•
•
Charge very low commissions
Give stripped-down service
No investment advice
Communications usually by emails
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Cash or Margin Account




Cash account
Full payment
Margin account
Pay a percentage
Settlement in three (3) business days for
both type of account
Margin percentage set by the Federal
Reserve Bank
•
•
•
•
Used to control speculation
10% in 1920s
80% in 1968
50% since 1974
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Long or Short? –
That is the Question
ACTION
OBJECTIVE
POSITION
Buy stocks
Profit from expected
increase in price
Long
Sell stocks
(not owned)
Profit from expected
decline in price
Short
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Types of Orders


Market order – usually trade close to the last
price
Limit orders
• When buying – pay NO more than the limit price
• When selling – receive no less than the limit price

Stop order - an order to buy or sell a stock
once the price of the stock reaches a
specified price, known as the stop price.
When the specified price is reached, the
stop order becomes a market order
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Length of Time for Executing
Orders to Buy/Sell Securities


Day orders – expire at the end of the day
Good till canceled (GTC) - order to buy or
sell a security that is good until the
investor decides to cancel it
• Most brokerage firms let GTC orders
automatically expire after 30 - 60 days
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Cost of Trading

Full-service brokerage
• Merrill Lynch
• UBS PaineWebber
• Morgan Stanley Dean Witter

Discount brokers
• Charles Schwab
• Quick &Reilly
• Olde

Online brokers
• Ameritrade
• E-trade
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Effects of Pricing Differential
Example: 100 shares traded at
$40/share i.e. total of $4,000
Broker type
Commission/Total trade
%
commission
Online
$15/$4,000
0.37
Discount
$42/$4,000
1.05
Full-service
$100/$4,000
2.50
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Other Factors to Consider before
Choosing the Type of Brokerage Service


Degree of sophistication of the investor
Degree of complexity of the investment
•
•
•
•

Capital gains tax implications
Potential merger offers
Retirement planning
Estate planning
ALL the above may outweigh savings in
commissions
35
The Merits and Drawbacks of
Internet & Online Trading
Pros
Availability of instant
information
Cons
How to interpret the
information
Downloading
 Balance sheets
 Income statement
 Up-to-the-minute press
releases
The requirement to know
Accounting
Finance
Investment
Economics
(Hint: Google search for Free Tax
Edgar, requires free
Legal issues
registrartion)
36
Taxes and the 2003 Tax Act


Legal tax advice provided only by a CPA or
CFP (Certified Financial Planner)
Tax considerations could outweigh savings on
brokerage commissions
Please click on the following icon for a
summary of the 2003 Tax Act
www.turbotax.com
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Calculating the Marginal Tax Rates
Example: Single - taxable income of $34,000
Amount
First $7,000
Rate in %
10%
Tax in $
$700
Next $21,400*
15%
$3,210
Next $5,600**
25%
$1,400
$5,310
* $28,400 – $7,000
** $34,00 - $28,400
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Calculating the Average Tax
Example: Single - taxable income of $34,000


Amount of taxes paid
Divided by taxable income
Taxes paid
$5,310.10
=
Taxable income
$34,000.00
Average Tax Rate = 15.62%
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Capital Gains and Dividends

Capital gain or loss
• Asset held for investment purposes
• Sold
Asset held for more than one year
Long-term capital gain
Max tax rate on dividends 15%
40
Comparing Taxes
Long-term Capital Gains
versus
Short-term Capital Gains
Holding Period
Profit
Tax Rate
Taxes
6 months
$10,000
35%
$3,500
Over 12 months
$10,000
15%
$1,500
41
Website
Comment
www.msci.com
Provides information on
bond and stock indexes
www.barra.com
Provides information on
various modified indexes
www.sec.gov
Provides access to SEC
filings
www.quicken.com
Provides access to
company SEC filings
finance.yahoo.com/
Profile pages on stock
quotes provide access to
company SEC filings
42
Website
Comment
www.standardandpoors.com
Contains information about S&P
indexes and the markets
www.dowjones.com
Provides information about the
Dow Jones indexes
www.ashkon.com/nasdaq-100.html
Components of NASDAQ-100
(QQQ)
http://www.investorwords.com
Investing glossary
http://finance.yahoo.com/etf/education/04
Exchange Traded Funds
http://finance.yahoo.com/q?s=QQQQ
Quotes and Information
www.sec.gov
US Security and Exchange
Commission’s website
www.bloomberg.com
Market data: rates & bonds
43