Sambo_MB_Ch8.docx

Price-weight average : these averages give greater weight to shares with hgiher prices Value-weighted average: these averages give greater weight to shares with larger markey capitalization Fundamental value: the fundamental value of a stock is based on the timing and uncertainy of the returns it brings. So the value of the firm?s stock depends on both is current assets and on estimates of its futire profiablitly. Dividend discount model : Leverage: the practice of borrowing to finance part of an investment. Examples incude borrowing to buy stok ( through what is called margin loans), corporate borrowing (using bonds), and borrowing to buy a house (mortgages). Stocks are risky because the shareholds are residual claimants. Stock prices are high when : Current dividends are high Dividends are expected to grow quickly Risk free rate is low Risk premium on equity is low Return to holding stock for one year : Dividend discount model for one year: Required stock return (i) = risk free return (rf) + risk premium (rp) Theory of Efficient Markeys : the notion that the prices of all finacnial instruments, including stocks, reflect all available information. As a result, markey adjust immediately and continuously to changes in fundamental values. It implies tthat stock price moevements are unpredictable. Some managers claim to do well but this brings only 4 possiblities: 1. They have private information which is illegal 2. They are taking on risk, which brings added compensation but means that at times returns will be extremely poor 3. They are lucky 4. Markets are not efficient Mutual Funds: There are five issues to think about when buying stock: affordability, liquidity, diversification, management and cost. Prepackaged portfolios are called mutual funds. How do you choose a mutual fund. 1. Affordability. Most mutual finds allow a small initial investment. You can start with as little as $1,000. 2. Liquidity. In an emergency, you may need to withdraw your resources quickly. Make sure you withdraw your investment easily if you need to. 3. Diversification. TH evast majority of mutual funds are much more diversificed thatn any portfolio of stocks, Even, So it is important to check before you buy. 4. Management. Mutual funds offer the advantage of professional management. You do need to be careful, as funds in which people make the decisions, so-called managed funds, tend to perform worse than index funds, which are designed to mimic stock market indexes, 5. Cost. Mutual fund managers charge fees for their services. The fees for managed funds run about 1.5 percent per year, compared to .5 or less for index funds. This is a significant difference. Over 20 years, an investment of $10,000 with an average annual return of 8% will amount to $46,610Index fund or index tracker : is a collective investment scheme (usually a mutual fund or exchange-traded fund) that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions. Tracking can be achieved by trying to hold all of the securities in the index, in the same proportions as the index. Other methods include statistically sampling the market and holding "representative" securities. Many index funds rely on a computer model with little or no human input in the decision as to which securities are purchased or sold and is therefore a form of passive management. The lack of active management usually gives the advantage of lower fees and lower taxes in taxable accounts. However, the fees will generally reduce the return to the investor relative to the index. In addition it is usually impossible to precisely mirror the index as the models for sampling and mirroring, by their nature, cannot be 100% accurate. The difference between the index performance and the fund performance is known as the 'tracking error' or informally 'jitter'. Index funds are available from many investment managers. Some common indices include the Standard & Poor's 500, the Dow Jones Industrial Average the Wilshire 5000, the FTSE 100. Less common indexes come from academics like Eugene Fama and Kenneth French, who created "research indexes" in order to develop asset pricing models, such as their Three Factor Model. The Fama French Three Factor model is used by Dimensional Fund Advisors to design their index funds. Robert Arnott and Professor Jeremy Siegel have also created new competing fundamentally based indexes based on such criteria as dividends, earnings, book value, and sales.