Financial Management Focus - 3 Decisions

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7. Mutual Funds: A business that pools the money of many small savers and buys a portfolio of diversified securities. Savers will own a piece of the portfolio in direct proportion to the amount of money they have contributed to it.8.Exchange Traded Funds (ETFs)(tracking stocks): portfolio of securities, but they trade as a single stock (QQQ, SPY, DIA). The “stock” price goes up and down as the value of the portfolio it tracks goes up and down. Investors can buy shares of the ETF instead of the actual portfolio of securities it tracks.9.Hedge Funds: Largely unregulated mutual funds that are only available to sophisticated investors. Starts at $1 million. Take big risks and invest in securities (derivatives) that are not available to traditional stock and bond mutual funds.10.Private Equity Companies: Firms that buy other firms that are underperforming. Buy the entire firm and take over the management responsibilities. Face very little regulation because ownership is private.

The Stock Market: stocks of individual companies are actively traded in secondary market transactions .Physical Location Stock Exchanges: where traders meet face-to-face when executing trades. Only a limited number of traders. Membership is held by individuals and institutions. Non-members are not allowed to trade directly.

Ex.New York Stock Exchange (NYSE), American Stock Exchange (AMEX)

Over-the-Counter (OTC) and the NASDAQ Stock Markets: System of electronic networks linking securities traders.

- Sometimes referred to as dealer markets, these markets allow securities dealers to post bid and ask prices. Bid prices are the prices dealers will pay for shares and ask prices are the selling prices dealers will accept.

- Dealers actually trade with buyers and sellers from their own portfolio. The profit from the bid-ask spread.

- Brokers do not actually engage in trading activities. They simply bring buyers and sellers together and charge a fee for doing so. Physical location exchanges are mostly broker markets.

- NASDAQ stands for National Association of Securities Dealers Automated Quotation system.

- One characteristic of the OTC markets is that most of their securities are smaller companies or tech companies. The largest NASDAQ stocks are all tech companies (DELL, AMZN, INTC, MSFT, AAPL, GOOG, CSCO, ORCL).

Types of Stock Market Transactions

- Our textbook classifies stock market transactions as falling into one of three distinct categories:

- Existing shares trading in secondary markets.

- New shares of a publicly traded company being offered to the public in the primary market.

- A company offers its stock to the public for the first time with an initial public offering (IPO) in the primary market.

- IPO’s present unique challenges and opportunities because the market has not yet set a price for a new stock issue.

- Investment bankers guess at what the market believes the intrinsic value of the stock actually is. After an IPO, some stock prices rise dramatically while others may fall just as dramatically (see page 43 for some examples).

Stock Market Reporting: Access to real-time stock market information is readily available from many internet sites and smart phone applications.

- Stock Market Returns: Unlike money markets and even bond markets, the stock market is relatively volatile. The market as a whole may move dramatically up or down in any given year.

Stock market efficiency

Suggests that at any given time, stock prices fully reflect all available information on a particular stock and/or market.

In other words, market prices are accurate representations of intrinsic prices and the market is in equilibrium.

When stock prices are in equilibrium, their future movements will be random and based on new information.

Thus, no investor has an advantage in predicting future stock prices because no one has access to information not already available to everyone else. Investors, therefore, will not consistently beat the market (earn higher returns than the market as a whole).

Behavioral Finance Theory

- While the efficient markets hypothesis (EMH) remains driving force in finance theory, it does not always capture or explain the actions of all investors.

- Behavioral finance has emerged as an area that uses psychology to better understand irrational investor behavior.

- People respond differently to gains and losses.

- People tend to overestimate their own abilities (90% of people think they’re above average drivers).

- People take credit when they succeed

- People assign blame when they fail

Measuring the Market: Stock market indexes track the performance of the market as a whole. However, the various indexes are computed differently so there is some deviation in their respective conclusions. The three most commonly cited indexes are:

- Dow Jones Industrial Average (DJIA)

- The DJIA is an index based on 30 large industrial stocks that represent nearly 20% of the value of all stocks.

- Standard & Poor’s 500 Index (S&P 500)

- A broader index than the DJIA, the S&P 500 consists of 500 stocks from various industries.

- Stocks in the index are weighted by their market value, so larger companies influence the index more than smaller companies.

- Nasdaq Composite Index

- An index measuring the performance of all stocks listed

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