Forbes Stock Market Course

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Forbes Stock Market Course

  1. 1. FORBES STOCK MARKET COURSE Published by Forbes Investors Advisory Institute A Division of Forbes LLC Publishers of Forbes Magazine 60 Fifth Avenue New York, NY 10011 Edited by Vahan Janjigian, Ph.D., CFA V.P. & Executive Director Forbes Investors Advisory Institute Major Contributors: Stephen M. Horan, Ph.D., CFA Charles A. Trzcinka, Ph.D. Associate Professor of Finance Cozad Professor of Finance St. Bonaventure University Indiana University All rights reserved. All material in the Forbes Stock Market Course is copyrighted and cannot be reproduced or redistributed by any means without the prior written permission of Forbes Inc. Any infringement of copyright will be fully prosecuted under the law. © Forbes, Inc., 1948. Revised 2008. All rights reserved.
  2. 2. FORBES STOCK MARKET COURSE TABLE OF CONTENTS Page SECTION 1 – BUILDING CAPITAL 1 The Role of the Stock Market in Building Wealth ................................................. 1 Determining Your Financial Position ..................................................................... 3 Your Financial Inventory Guide ............................................................................. 3 Personal Balance Sheet Example ............................................................................ 10 Investment Margin ................................................................................................... 11 Defining Your Goals ............................................................................................... 12 Return Requirements ............................................................................................... 12 Risk Profile ............................................................................................................. 12 Life Cycle and Risk/Return Mix ............................................................................. 13 Other Considerations ............................................................................................... 14 Asset Classes ........................................................................................................... 14 Asset Allocation ....................................................................................................... 17 An Example of Asset Allocation ............................................................................. 17 Active versus Passive Investing .............................................................................. 19 Diversification ......................................................................................................... 19 Dollar Cost Averaging ............................................................................................. 20 How Dollar Cost Averaging Works ........................................................................ 22 Ideal Investments for Dollar Cost Averaging ......................................................... 25 SECTION 2 – HOW SECURITIES MARKETS FUNCTION 27 The Role of Security Markets ................................................................................. 27 The Securities Exchanges ....................................................................................... 29 Over-The-Counter Markets .................................................................................... 31 NASDAQ ................................................................................................................ 31 ECNs ....................................................................................................................... 32 Stock Quotes ........................................................................................................... 33 The Third Market ..................................................................................................... 33 Other Markets .......................................................................................................... 34 How Secondary Markets Operate ............................................................................ 34 How the NYSE Operates ........................................................................................ 34 How NASDAQ Operates ........................................................................................ 36 From SOES to SuperMontage ................................................................................. 37 OTC Bulletin Board and Pink Sheets ..................................................................... 38 i © 2008 Forbes Inc.
  3. 3. FORBES STOCK MARKET COURSE Page How the ECNs Operate ........................................................................................... 38 Crossing Systems ..................................................................................................... 39 Electronic versus Floor Trading .............................................................................. 39 Preferencing ............................................................................................................. 42 Internalization .......................................................................................................... 43 SECTION 3 – SELECTING A BROKER AND TRADING 44 Structure of a Brokerage Firm ................................................................................ 44 Activities of a Brokerage Firm ............................................................................... 45 Services Offered by all Brokers ............................................................................ 46 Full Service versus Discount Brokers ..................................................................... 46 Online Brokers ........................................................................................................ 47 Choosing a Brokerage Firm .................................................................................... 48 Commissions ............................................................................................................50 Direct Purchase of Securities .................................................................................. 52 Placing Orders ......................................................................................................... 52 Odd-Lot Trading .................................................................................................... 55 Margin ..................................................................................................................... 56 Transaction Example ............................................................................................... 57 Settlement ................................................................................................................ 58 Stock Symbols and the Ticker Tape ........................................................................ 58 Questions for Your Broker ...................................................................................... 61 SECTION 4 – TAX-FAVORED INVESTMENT STRATEGIES 62 Capital Gains and Dividends ................................................................................... 62 Traditional IRAs ...................................................................................................... 64 Roth IRAs ................................................................................................................ 65 401(k) Plans ............................................................................................................. 66 Education IRAs and 529 Plans ............................................................................... 67 Other Pension Plans ................................................................................................. 68 Mutual Funds and Taxes .......................................................................................... 70 Using Tax-Advantaged Accounts ........................................................................... 70 ii © 2008 Forbes Inc.
  4. 4. FORBES STOCK MARKET COURSE Page SECTION 5 – READING FINANCIAL STATEMENTS 72 Income Statement ................................................................................................... 73 Balance Sheet ......................................................................................................... 76 Statement of Cash Flows ......................................................................................... 79 Making Sense of the Numbers ................................................................................. 81 Profitability Ratios ................................................................................................... 82 Asset Utilization Ratios .......................................................................................... 85 Leverage Ratios ........................................................................................................ 87 Revisiting ROE ....................................................................................................... 88 Liquidity Ratios ....................................................................................................... 89 Market Multiples ..................................................................................................... 90 Look Beyond the Numbers ..................................................................................... 92 Read the Footnotes .................................................................................................. 93 Can You Trust Financial Statements? ...................................................................... 94 SECTION 6 – SOURCES FOR INVESTMENT INFORMATION 97 Where to Obtain Information .................................................................................. 99 Securities and Exchange Commission ..................................................................... 100 Earnings Releases and Regulation Fair Disclosure (FD) ........................................ 101 Investment Brokers and Dealers ............................................................................102 Can You Trust Brokerage House Reports? .............................................................103 Investment Newsletters and Other Publications .....................................................104 Corporate Reports ...................................................................................................105 Reading the Annual Report .....................................................................................105 Government Reports ...............................................................................................106 SECTION 7 – COMMON STOCKS AND ECONOMIC INDICATORS 107 Another Look at the Balance Sheet ........................................................................107 Why Common Shares Have Value .........................................................................109 Macroeconomic Factors .........................................................................................110 Industry Specific Factors ........................................................................................113 Other Barometers ....................................................................................................114 Evaluating Data .....................................................................................................114 iii © 2008 Forbes Inc.
  5. 5. FORBES STOCK MARKET COURSE Page SECTION 8 – FUNDAMENTAL ANALYSIS 116 Investing versus Trading ........................................................................................116 Passive Investing .....................................................................................................117 Active Investing ......................................................................................................117 Business Focus ........................................................................................................122 Industry Outlook .....................................................................................................123 Company Status ......................................................................................................124 Major Trends ..........................................................................................................125 Earnings History and Outlook ................................................................................126 Dividends ................................................................................................................127 Price-Earnings and Price-Book Ratios Revisited ...................................................128 Discounted Cash Flow ............................................................................................130 Evaluating Management .........................................................................................130 Some Final Thoughts on Fundamental Analysis ....................................................131 SECTION 9 – TECHNICAL ANALYSIS 133 The Value of Charts ................................................................................................134 Reading Charts .......................................................................................................136 Dow Theory ............................................................................................................137 Head and Shoulders ................................................................................................140 Support and Resistance Levels ...............................................................................141 Trading Ranges .......................................................................................................142 Break-Away Gaps ...................................................................................................143 The Importance of Volume .....................................................................................144 Other Technical Indicators .....................................................................................147 Time to Grow Bullish .............................................................................................149 SECTION 10 – FIXED-INCOME SECURITIES 152 Bonds ......................................................................................................................152 Understanding Bonds .............................................................................................153 Understanding Bond Prices ....................................................................................154 Bond Prices and Interest Rates ...............................................................................155 Call Feature .............................................................................................................156 Credit Quality of Bonds .........................................................................................156 Other Issues Concerning Bonds ..............................................................................158 iv © 2008 Forbes Inc.
  6. 6. FORBES STOCK MARKET COURSE Page How to Buy Bonds .................................................................................................160 Money-Market Securities .......................................................................................160 Preferred Stock .......................................................................................................161 Understanding Preferred Stock ..............................................................................162 Tax Treatment ........................................................................................................164 Trust Preferred Securities .......................................................................................164 Final Thoughts on Bonds and Preferred Stocks .....................................................165 SECTION 11 – DERIVATIVES 166 Defining Derivative Instruments ............................................................................166 Futures ....................................................................................................................167 Spot Asset ...............................................................................................................167 The Futures Market ................................................................................................168 Delivery ..................................................................................................................169 Hedging ..................................................................................................................169 Stock Index Futures ................................................................................................170 Single Stock Futures ...............................................................................................172 Options ....................................................................................................................173 Definition of Options ..............................................................................................173 Options Markets .....................................................................................................174 Important Terms to Know ......................................................................................174 Listed Options .......................................................................................................175 What an Option Is Worth .......................................................................................177 Commissions ..........................................................................................................179 To Sell or to Exercise ...........................................................................................180 Some Popular Option Strategies ............................................................................180 A Warning about Naked Option Writing ...............................................................183 SECTION 12 – MUTUAL FUNDS 185 An Investment Company ........................................................................................185 Closed-End or Open-End .......................................................................................185 A Short History of the Mutual Fund Industry .......................................................187 Categories of Mutual Funds ...................................................................................187 Advantages of Mutual Funds .................................................................................191 Disadvantages of Mutual Funds .............................................................................192 v © 2008 Forbes Inc.
  7. 7. FORBES STOCK MARKET COURSE Page Mutual Fund Expenses ...........................................................................................194 How to Choose a Fund ...........................................................................................196 Some Final Thoughts about Mutual Funds .............................................................196 Hedge Funds ...........................................................................................................197 SECTION 13 – RULES OF THUMB AND KEY PHRASES 200 Final Comments .....................................................................................................205 Suggested Readings ................................................................................................206 vi © 2008 Forbes Inc.

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