Chapter3OnlineInformationandInvesting33

Chapter3
InvestmentInformationandSecuritiesTransactions

Outline
Learning Goals
I.

OnlineInvesting
A) TheGrowthofOnlineInvesting
1. InvestmentEducationSites
2. InvestmentTools
a. Planning
b. Screening
c. Charting
d. StockQuotesandPortfolioTracking
3. ProsandConsofUsingtheInternetasanInvestmentTool
ConceptsinReview

II.

TypesandSourcesofInvestmentInformation
A) TypesofInformation
B) SourcesofInformation
1. EconomicandCurrentEventInformation
a. FinancialJournals
b. GeneralNewspapers
c. InstitutionalNews

34Gitman/JoehnkFundamentalsofInvesting,NinthEdition

d. BusinessPeriodicals
e. GovernmentPublications
f. SpecialSubscriptionServices
2. IndustryandCompanyInformation
a. FairDisclosureRules
b. StockholdersReports
c. ComparativeDataSources
d. SubscriptionServices
e. BrokerageReports
f. InvestmentLetters

Chapter3OnlineInformationandInvesting35

3. PriceInformation
4. OtherOnlineInvestmentInformationSources
a. FinancialPortals
b. BondSites
c. MutualFundSites
d. InternationalSites
e. InvestmentDiscussionForums
5. AvoidingOnlineScams
ConceptsinReview
III. UnderstandingMarketAveragesandIndexes
A) StockMarketAveragesandIndexes
1. TheDowJonesAverages
2. Standard&PoorsIndexes
3. NYSE,AMEX,andNasdaqIndexes
4. ValueLineIndexes
5. OtherAveragesandIndexes
B) BondMarketIndicators
1. BondYields
2. DowJonesCorporateBondIndex
3. NYSEBondDiary
ConceptsinReview
IV. MakingSecuritiesTransactions
A) TheRoleofStockbrokers
1. BrokerageServices
2. TypesofBrokerageFirms
3. SelectingaStockbroker
4. OpeninganAccount
a. SingleorJoint
b. CashorMargin
c. Wrap
5. OddLotorRoundLotTransactions
B) BasicTypesofOrders
1. MarketOrder
2. LimitOrder
3. StopLossOrder

36Gitman/JoehnkFundamentalsofInvesting,NinthEdition

C) OnlineTransactions

Chapter3OnlineInformationandInvesting37

1. DayTrading
2. TechnicalandServiceProblems
3. TipsforSuccessfulOnlineTrades
D) TransactionCosts
E) InvestorProtection:SIPCandArbitration
ConceptsinReview
V.

InvestmentAdvisorsandInvestmentClubs
A) UsingInvestmentAdvisors
1. RegulationofAdvisors
2. OnlineInvestmentAdvice
3. TheCostandUseofInvestmentAdvice
B) InvestmentClubs
ConceptsinReview

Summary
PuttingYourInvestmentKnowHowtotheTest
DiscussionQuestions
Problems
CaseProblems
3.1 ThePerezesGoodFortune
3.2 PeterandDeborahsChoicesofBrokersandAdvisors

38Gitman/JoehnkFundamentalsofInvesting,NinthEdition

ExcelwithSpreadsheets
TradingOnlinewithOTIS

.1

Key Concepts

1.

TheInternetempowersindividualinvestors,providessavingsintimeandmoney,andofferscurrent
informationformerlyavailableonlytoinvestingprofessionals.Toolssuchasfinancialplanning
calculatorsandmorearefree,makingbuyingandsellingonlineconvenient,relativelysimple,
inexpensive,andfast.

2.

Therole,types,andusesoftraditionalandonlineinvestmentinformationformakinginvestment
decisions.

3.

Someofthekeysourcesofinvestmentinformationforeconomicandcurrentevents.

4.

Sourcesofinformationtoassesstheperformanceofspecificindustries/companies.

5.

Themostcommonlycitedmarketaveragesandindexes,theirinterpretation,andtheiruseinassessing
marketconditions.Bothstockandbondindexarecovered.

6.

Theroleofthestockbrokerinmakingsecuritytransactions,thetypesofbrokerageservicesavailable,
andthevarioustypesofbrokerageaccounts.

7.

Acomparisonoffullservice,premium,anddiscountbrokerageservices.

8.

Thebasictypesofordersmarket,limit,andstoploss,theiruseinmakingsecuritytransactions,and
transactioncosts.

9.

Theproductsandservicesoffered,regulation,types,andcostofinvestmentadvisors.

10. Theinvestmentclubasadeviceforpoolingknowledgeandmoneytocreateandmanageajointly
ownedportfolio.

.2

Overview

1.

TheInternetandonlineinvestingoffertheindividualinvestoradvantagesonceenjoyedbyonlythe
professionalinvestor.Thenumberofhouseholdsusingonlineinformationforinvestmentpurposesis
quicklyexpanding.ThechallengenowistousethetoolsofferedbytheInternetwisely.

2.

Investmentinformationisbroadlyclassifiedintodescriptiveandanalyticalinformation.Itis
importantthatstudentsunderstandthedifferencebetweenthesetwokindsofinformationandthe
investorsneedforbothtypes.Onlineinvestmenttoolshelpinvestorsplan,screen,chartindividual
securities,andtrackportfolioperformance.

3.

Thechapternextmentionsthebenefitsandcostsofobtaininginvestmentinformation.Theinstructor
shoulddrivehomethepointthatalthoughaninformedinvestormayperformbetterinthelongrun,
obtainingandanalyzinginformationcoststheinvestormoneyandtime.Therefore,aninvestorshould
analyzetheworthofinformation.

Chapter3OnlineInformationandInvesting39

4.

Fivedifferenttypesofinformationaredelineated,andtheinstructorshouldpointoutthataninvestor
usuallyneedsallfivetypes.Forexample,knowledgeaboutaparticularcompanyalonewouldbe
insufficientforinvestmentdecisionmaking.Theinvestorwouldalsorequireinformationaboutthe
economy,currentevents,theindustry,andmarketpricesinordertobeabletomakeagooddecision.

5.

Thetextmentionsanumberofspecificsourcesofinformation,appropriatelybeginningwithThe
WallStreetJournal.Variousotherfinancialpublicationsprovideinformationofdifferenttypes.The
instructormightrequirestudentstobringtheirowncopiesoftheWSJtoclassandgothroughvarious
sectionswiththem.Thisisagoodwaytodemonstratehowtoreadstockpricequotations,aswellas
bond,option,mutualfund,commodity,andotherquotations.Theinstructormightalsofindituseful
tobringacompanystockholdersreporttoclassandexplainitscontents.Presentingcurrentexamples
ofInternetsitesalsoworkswell.

6.

Thepopularmarketaveragesandindicesarepresentednext.Movementsinmarketaveragesare
importantindicatorsofthestateoftheeconomy;theinstructorshoulddescribe,inclass,stockmarket
indicessuchastheDowJones,theS&P,andtheNYSEindex,specifyingwhattheseindicesmeasure,
andshowinghowtofindrecentlistingsintheWSJ.Thebondyield,whichprovidesadditional
informationaboutthemarketandtheeconomy,shouldbedefinedandthelistingofvariousyields
pointedoutintheWSJ.

7.

Thenextpartexaminestheroleofstockbrokersandtheservicestheyprovide.Studentsusually
encounterdifficultieswiththeconceptsofmargintrading,market,limit,stoplossorders,andshort
selling.Therefore,theinstructorshoulddevoteadequatetimetocoverthesetopicsanduseexamples
forclarification.

8.

TheroleoftheSIPCinprotectinginvestorsandproceduresforsettlingdisputesbetweeninvestors
andbrokeragefirmsisexplained.

9.

Thenatureandfunctionsofinvestmentadvisorsarediscussednext.Thestructureandregulationof
theiractivitiesandthetypesofinformationtheyprovidearedescribed.Thechaptercloseswitha
discussionofinvestmentclubs.

Answers to Concepts in Review

1. In addition to providing low cost investing, the Internet supplies a multitude of information sources
designed to assist the individual investor in the decision making process. Investment education sites
range from the tutorials and online classes that educate the novice investors to the financial
calculators and worksheets used by experienced investors.
2. The four types of online investment tools are as follows:
(a) Planning. Online calculators and worksheets help you find answers to your financial planning and
investing questions.
(b) Screening. Screening tools help you sort through huge databases of stocks and mutual funds to
find those that have specific characteristics.
(c) Charting. This technique allows you to plot the performance of a stock or a group of stocks over a
specified time period.
(d) Stock Quotes and Portfolio Tracking. This tool allows the investor to track his or her investment,
to be alerted whenever an analyst changes the rating, or to indicate how well the portfolio is
diversified among major asset classes.

40Gitman/JoehnkFundamentalsofInvesting,NinthEdition

3. As for the advantages of online investing, it is now possible for even novice investors to participate in
the stock markets with a huge amount of information available at their fingertips to assist in making
their decisions to invest.
On the con side, trading on the Internet requires that investors exercise the same caution they would if they
were getting information from a human broker. Furthermore, you dont have the safety net of dealing
with a human who may be suggesting that you exercise additional caution. The ease of the point-andclick investing can be the financial downfall of inexperienced investors. Transaction costs add up and
margin trading results in interest payments on the loan that will reduce possible gains.
4. Descriptive information is factual information on past behavior of the economy, the market, or a given
investment vehicle. Analytical information, on the other hand, tends to analyze existing data and
make projections and is quite often a source of recommendations for potential investments. The
investor must evaluate whether the costs of acquiring the information are justified by the potential
increase in return. There are either direct or indirect costs associated with information gathering.
Direct costs include subscription fees and advisors fees. Indirect costs include the time involved to
gather information.
5. The Wall Street Journal, published by the Dow Jones, is perhaps the most popular source of financial
news in this country. Published daily, it provides daily price quotations on a multitude of securities. It
also has a wealth of world reports, national reports, and regional and corporate news. Regular
features, like Your Money Matters, address topics of interest to individual investors. Barrons, on
the other hand, is a weekly publication also published by Dow Jones. However, the articles in
Barrons are generally more in-depth and directed to financial issues than those in The Wall Street
Journal. Barrons also has special interest columns like Up and Down Wall Street. In addition,
there are current price quotations and summary statistics on a wider variety of investment vehicles.
Other sources of financial news include Investors Business Daily and the Financial Times.

Chapter3OnlineInformationandInvesting41

General news is available from a variety of published sources, especially daily newspapers in the local
community. Many business people also rely on daily papers that have national reputations in the
political and economic arena such as The New York Times and the Los Angeles Times. USA Today is a
national daily newspaper containing a Money section devoted to business and personal financial
news. Time and Newsweek are also major periodicals in the general news category.
Business news articles and statistics on general business and economic activities in the United States and
abroad can be found in The Wall Street Journal and in such magazines as Newsweek, Time, U.S. News
& World Report, BusinessWeek, Fortune, The Economist, Federal Reserve Bulletin, and the Survey of
Current Business. A variety of articles discussing the activities of securities markets and corporations
can be found in The Wall Street Journal, Barrons, Investors Business Daily, Forbes, Kiplingers
Personal Finance, Money, and Smart Money. The last three are oriented toward individual investors
and managing personal finances. Local metropolitan newspapers also provide information on
securities of local interest.
There has been a blurring of the distinctions between print sources and online sources, because many of
the print sources now make their information available online. Two advantages of the online sources
is the limited amount of advertising and ability to be continually updated. Of course, online sources
generally require readers to be at a terminal, and carrying a computer with you is not as convenient as
simply grabbing the printed material.
6. (a) The stockholders report, also called the annual report, is an annual publication of publicly held
corporations. These reports are usually free and contain a wealth of descriptive and analytical
information, including financial statements, about the firm. Stockholder reports are just one of
the pieces of information that can be downloaded from company web sites.
(b) Comparative data sources enable investors to analyze the financial condition of companies and are
typically grouped by industry and size of firm. These include Dun & Bradstreets Key Business
Ratios, RMAs Annual Statement Studies, the Quarterly Financial Report for U.S. Manufacturing,
Mining, and Wholesale Trade Corporations, and the Almanac of Business & Industrial Financial
Ratios.
(c) Standard and Poors Stock Reports is a major service of the Standard and Poors Corporation. It
contains up-to-date reports on numerous firms, including a summary of the firms financial
history, its current financial situation, and for NYSE companies, an opinion on the firms future
prospects.
(d) Mergent provides detailed financial information on companies and industries.
(e) Value Line Investment Survey offers ratings for all widely held stocks with full-page reports
including financial data, descriptions, analysis, and advice.
7. (a) The prospectus is part of the registration statement required by the SEC on a new security issue. It
describes in detail the key aspects of the issuer, its management and financial position, and the
security to be issued. Brokerage firms provide prospectuses at no cost to their clients. (Note: This
information source is available only when a firm is making an issue of new securities.)

42Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(b) Back office research reports present analyses and recommendations on the current and future prospects
for the security markets, specific industries, and specific securities. These are prepared by brokerage
firm research staffs and are available (usually free of charge) to existing as well as potential clients.
Several information vendors, such as Reuters and Zacks, consolidate research from many companies
and put it on the web.
(c) Investment letters provide the conclusions and recommendations of various analysts. Common
examples of investment letters are Blue Chip Advisor, The Dines Letter, Dow Theory Letters, the
Growth Stock Outlook, and Zacks Advisor. Although some investment letters concentrate on specific
types of securities, others are concerned solely with assessing the economy and/or security markets.
There is a fee for subscription to these (generally) weekly or monthly letters. The Hulbert Financial
Digest monitors the performance of investment letters.
(d) Price quotations include the current prices and price statistics for various types of securities.
Almost all brokerage houses have automated devices for obtaining up-to-the-minute quotations.
Many firms still use a ticker, a lighted screen on which stock transactions made on the floor of
the exchange are reported immediately as they occur. The stock names are shown in an
abbreviated form called ticker symbols. Recently, more firms have acquired sophisticated
computer terminals to more efficiently provide up-to-the-minute stock price information. The
most common sources of such information, however, are the daily newspaper and The Wall Street
Journal, which contains current quotations on numerous investment vehicles. Barrons and
Investors Daily also provide a wealth of security price quotations, which is especially useful for
bond quotations.

8. Electronic and on-line investment information allows individual investors to get timely historical and
current information such as stock quotes and economic and financial information. In addition,
investors may use their personal computer (PC) to access CD-ROM and diskettes for investment
information, financial data, and/or analysis software. Most of the online services charge initial,
monthly, and/or usage fees. Charges sometimes vary depending on the time of day the service is
accessed. Table 3.4 provides a listing of popular sites and a description of the unique data found there.
9. Stock market averages and indexes are used to measure the general behavior of securities markets.
Averages reflect the arithmetic average price behavior of a certain group of stocks at a given point in
time, whereas indexes measure the current price behavior of the group relative to a base value set at
an earlier point in time.
Averages and indexes provide a convenient way of capturing the general mood of the market. When the
averages or indexes reflect an upward trend in prices, a bull market is said to exist. Likewise, when
these measures exhibit a downward trend, a bear market exists.
10. (a) The four Dow Jones Averages include the Dow Jones Industrial Average (thirty widely-held stocks
issued by large firms), the Dow Jones Transportation Average (twenty transportation stocks), the
Dow Jones Utility Average (fifteen public utility stocks), and the Dow Jones U.S. Total Market
Index (includes all of the above).

Chapter3OnlineInformationandInvesting43

(b) The six Standard and Poors (S&P) Indexes include the S&P 400 Industrial Index (400 industrial
firms), the Transportation Index (twenty transportation companies), the Utilities Index (forty
public utility stocks), the Financials Index (forty financial stocks), the Composite Index (includes
the five hundred stocks in the S&P indexes mentioned above), the MidCap Index (four hundred
medium-sized companies), the SmallCap index (made up of six hundred small-sized companies);
and the fifteen hundred SuperComp index, which includes all stocks in the Composite, MidCap,
and SmallCap indexes.
Nearly all these indexes can be found in financial newspapers such as The Wall Street Journal, Barrons,
Investors Business Daily, and local newspapers in major metropolitan areas.
11. (a) The New York Stock Exchange Index includes the 2,100 stocks listed on the New York Stock
Exchange. It is calculated in a manner similar to the S&P Indexes. This index reflects the value of
the stocks listed on the NYSE relative to a base of 5000 set on December 31, 2002.
(b) The American Stock Exchange Index reflects the price of shares on the American Stock Exchange
relative to a base of 550 set on December 29, 1995.
(c) The Nasdaq Stock Market Indexes reflect the behavior of the Nasdaq stock market. The most
popular, the Nasdaq Composite Index is calculated using more than 4,000 domestic common
stocks traded on the Nasdaq system. The index is based on a value of 100 set on February 5,
1971. Another popular Nasdaq index is the Nasdaq 100, which includes one hundred of the
largest domestic and international non-financial companies that are listed on the Nasdaq.
(d) The Value Line Composite Average includes the approximately 1,700 stocks in the Value Line
Investment Survey and traded on a broad cross section of exchanges as well as in the over-thecounter market. The base of 100 reflects the June 30, 1961, average of the stocks.
12. (a) Bond yields capture the behavior of market interest rates and represent a type of summary measure
of the return an investor would receive on a bond if it were held to maturity. Barrons quotes the
yields on the Dow Jones bond average of ten high-grade corporate bonds and ten medium-grade
corporate bonds, a ratio of the high-grade yield to the medium-grade yield is calculated and
known as the confidence index.
(b) The Dow Jones Corporate Bond Index, quoted in The Wall Street Journal and Barrons, is the
mathematical average of the closing prices of thirty-two industrial, thirty-two financial, and
thirty-two utility/telecom bonds.
13. Stockbrokers help investors buy and sell securities. Besides this major role, full-service stockbrokers
provide clients with several other benefits. For example, most brokerage firms offer their clients a
wide variety of information. Many of them have research staffs that periodically review published
economic, market, industry, or company behavior forecasts and make recommendations to their
clients as to which securities they should buy or sell. Every month they mail investors a record of
transactions for that month with a total ending balance. Some brokerage firms also make
arrangements to transfer funds from the sale of securities directly to an investors savings account,
where the funds can earn interest. Many brokers have reference libraries that clients can use to
research securities. They can provide up-to-the-minute stock price quotations. Many brokerage firms
will also hold certificates for safekeeping to protect against loss.

44Gitman/JoehnkFundamentalsofInvesting,NinthEdition

The major role of a stockbroker is to execute a clients transactions at the best possible price. While it is
not necessary to know your stockbroker personally, he or she should understand your investment
goals. This should avoid potential conflicts. You should also make sure that the broker does not
charge you too much for the services provided, and that you are not paying for services that you do
not need.
14. (a) A brokerage account may be either single or joint. Joint accounts are typically between married
couples or between parent and child.
(b) A custodial account is one in which a parent or a guardian will take responsibility for all
transactions undertaken on behalf of a minor.
(c) A cash account is one in which a customer can only use cash to make transactions. This is perhaps
the most common type of account.
(d) A customer who wishes to trade in securities using borrowed money establishes a margin account.
By leaving the securities with the brokerage firm as collateral, the customer can borrow a prespecified amount to trade in securities. Needless to say, the brokerage firm will first verify the
customers creditworthiness before opening a margin account in that customers name.
(e) A wrap account is an account in which customers with large portfolios pay the brokerage firm a
flat annual fee, typically between 2 and 3 percent of their portfolios total asset value, to cover the
combined costs of a money managers services and the cost of commissions on their trades.
These accounts allow the wealthy investor to conveniently shift the burden of stock-selection
decisions to a professionaleither in-house or independentmoney manager.
15. A market order is an order to buy or sell a security at the best price available at the time the order is
placed. It is the quickest way to make securities transactions. A limit order is an order to buy stock at
or below or to sell stock at or above a specified price. It is best used when securities prices fluctuate
widely. A stop-loss order is an order to buy or sell the stock when its market price reaches or drops
below a specified level. It is used primarily by investors who wish to protect themselves from a rapid
decline in the price of the stock. The stop-loss order gives them the opportunity to sell the stock when
the price declines to the stop price, thereby reducing their potential losses. It becomes a market order
and may in fact be executed at a lower price than the price at which the order was initiated.
16. Typically, brokers charge fixed commissions in return for facilitating the purchase or sale of securities.
Negotiated commissions are also available to investors who maintain large accounts with the broker.
The commissions usually vary depending on the services the broker provides to the investor. The
major difference between a full-service and discount broker is the full-service broker provides
investment advice. Because investing through a discount or deep-discount broker can save from 30 to
80 percent of the commission, the investor must weigh the benefit of advice against the higher
commission. Online brokers are typically deep discount brokers through whom investors can execute
trades electronically online. These brokers charge very low commissions but offer little or no
individualized research, information, or investment advice.
Full service brokers provide personalized, timely research and information. Basic discounters provide low
costs and fast trades. Premium discount brokers are in between these extremes.

Chapter3OnlineInformationandInvesting45

17. Day trading is the opposite of a buy-and-hold strategy since true day traders do not even own stocks
overnight. The method is highly risky since it often involves margin and short transactions that may
result in total loss. In addition, day traders have high expenses for brokerage commissions, training,
and computer equipment.
There are several important factors you should consider before trading securities. First, know how to place
and confirm your order before you begin trading. Second, verify the stock symbol of the security you
wish to buy. Third, use limit orders. Fourth, dont ignore the online reminders that ask you to check
and recheck. Fifth, dont get carried away. Sixth, open accounts with two brokers. Lastly, doublecheck orders for accuracy.
Many investors set aside an amount of their capital that is designated for purely speculative purposes and
not required for day-to-day survival. In this way, they are not jeopardizing themselves or their loved
ones if they suffer heavy losses.
18. Most firms use a fixed-commission schedule for individual investors with accounts less than $50,000.
Traditional brokers generally charge on the basis of the number of shares and price per share (e.g.,
market value of the purchase). They sometimes charge an annual management fee and lower
commissions. Online brokers, by comparison, charge a flat rate for transactions of up to 1,000 shares.
Online investors will pay a surcharge if they seek personalized broker assistance.
19. The Securities Investor Protection Corporation (SPIC), a nonprofit membership corporation, was
authorized to protect customer accounts against the consequences of financial failure of the brokerage
firm.
Mediation is an informal, voluntary approach in which you and the broker agree to a third party who
facilitates negotiations between the two of you to resolve disputes. If mediation is not pursued or it
fails, you may choose arbitration, a formal process whereby you and your broker present the two
sides of the argument before a panel of third party individuals.
20. Investment advisors are individuals or firms who advise clients about portfolio management. This may
be done on a discretionary basis, in which case the advisor has complete control over the clients
portfolio. In other cases, the advisor provides investment information and advice, and the client
makes his or her own investment decisions. Professional investment advisors are required to register
and file regular reports with the SEC under the Investment Advisers Act of 1940; a 1960 amendment
gave the SEC broader powers to monitor their activities. However, those who provide investment
advice in addition to their primary job responsibilitysuch as financial planners, stockbrokers,
bankers, and accountantsare not regulated by the Act. Many states have similar legislation. It is
important to remember that these laws only protect against fraud and unethical practices. They do not
provide the investor any indication of the quality of investment advice. Professional investment
advice usually costs between one-quarter of 1 percent and 3 percent annually of the amount of money
being managed. For larger portfolios, the fee is in the range of one-quarter percent to three-quarters
percent; for small portfolios the annual fee ranges from 2 to 3 percent of the dollar amount of funds
managed.

46Gitman/JoehnkFundamentalsofInvesting,NinthEdition

21. Investment clubs offer the individual investor access to information and/or advice from a broad range
of differently experienced people who have similar attitudes, investments strategies, and goals. Also,
through the investment club the individual investor can participate in a larger, and probably more
diversified, investment portfolio, therefore increasing the probability of earning a favorable return on
his or her investments. For the novice investor, a club can provide an excellent mechanism for
learning key aspects of portfolio construction and investment management.
Investment clubs regularly outperform the market and the professional money managers because they buy
stocks for the long term instead of trying to time the market.

Suggested Answers to Discussion Questions

Questions 1 to 4 and 6 will have answers that will vary depending on the choices made by the student.
5. You should ask a broker about how much experience they have and whether they have been involved in
any disciplinary actions by the SEC. You should ask if they have a minimum account size for new
clients. You should also ask how they construct portfolios or choose investments for their clients. Their
response should include consideration of each clients individual needs and circumstances.
7. (a) Market orders are used when investors wants to buy or sell a security quickly and are willing to trade
at the current market price.
(b) Limit orders are used when investors want to buy or sell a security and want to trade at a specified
price.
(c) Stop-loss orders are used when investors want to protect themselves from significant losses. After
buying a security they enter these orders at a price below their purchase price to limit the amount
of their potential loss.
8. Answerswillvarywitheachstudentsresearch.

Chapter3OnlineInformationandInvesting47

.1

9. The advice given by the large investment brokerages such as Prudential Securities and Morgan
Stanley Dean Witter is backed by a back office of analysts and a full line of services for the investor.
For the investor who has little time to do the research and to monitor his or her portfolio, this type of
advice is usually preferable. On the other hand, novices and an army of do-it yourselfers would
probably prefer the online advice sites. Membership in an investment club is often attractive to the

investors who have relatively small amounts to invest but who

have high risk aversion.
.2

Solutions to Problems

1.

(a) Costofresearch:

10hoursat$10perhour
$100
Researchdata
75
Total
$175
(b) Increaseinexpectedreturn:
Newreturnof10%Currentreturnof8%2%increase
$10,000investment.02increase
$200
(c) Yes;theexpectedincreaseinreturnisgreaterthanthecostofdoingtheresearch.

2.

MiniDowAverage(MCA)ClosingPrice

ClosingPrice

+...+ ofStock5
MCADivisor
$65 $37 $110 $73 $96
381
(a) MDAToday

498.04
0.765
0.765
$74 $34 $96 $72 $87
363
MDA1YearAgo

459.49
0.790
0.790
(b) ThevalueoftheMDAtodayis38.55pointshigherthanoneyearago(498.04459.49);this
generalupwardtrendindicatesabull(rising)market.
ofStock1

3.

SP6Index

CurrentClosingMarket

CurrentClosingMarket

ValueofStock1
+...+ ValueofStock5
BasePeriodClosing
BasePeriodClosing
MarketValueofStock1+ ... +MarketValueofStock5
(a) SP6Index
$460
$1120

$990

$420

$700

$320 $4010
Jan.1,2005
$240$630$450$150$320$80
1870
2.144100
214.4
SP6Index
$430
$1150

$980

$360

$650

$290 3860
June30,2005
$240$630$450$150$320$80
1870
2.064100
206.4
(b) TheSP6Indexhasmovedfrom100inthebaseyearto214.4onJan1,2002and206.4on
June30,2002,whichrepresentsagainof114.4%and106.4%respectively.TheSP6Indexfell
8points,from214.4onJanuary1,2002,to206.4onJune30,2002.Thegeneraldownwardtrend
indicatesabear(falling)market.

48Gitman/JoehnkFundamentalsofInvesting,NinthEdition

4.

MarketAverage

ClosingPriceofStockA+...+ClosingPriceofStockF
Divisor

(a)

MarketAverage2002
MarketAverage2005

$50 $10 $7 $26 $45 $32

$170
170
1.00
$40 $36 $23 $61 $70 $30 $260

361.11
0.72
0.72
$46 $37 $20 $59 $82 $32 $276

394.29
0.70
0.70

MarketAverage1978

(b)

CurrentClosingMarket
CurrentClosingMarket
ValueofStockA
... ValueofStockF
MarketIndex =
BasePeriodCurrent
BasePeriodCurrent
MarketValueofStockA +...+ MarketValueofStockF
$50 $10 $7 $26 $45 $32 $170
MarketIndex1978

1
$50 $10 $7 $26 $45 $32 $170
1 10 10
$40 $36 $23 $61 $70 $30 $260
MarketIndex2002

1.529
$50 $10 $7 $26 $45 $32 $170
1.529 10 15.29
$46 $37 $20 $59 $82 $32 $276
MarketIndex2005

1.624
$50 $10 $7 $26 $45 $32 $170
1.624 10 16.24
(c) Boththemarketaverageandthemarketindexshowageneralupwardtrend,indicatingabull
market.
(d) Changeinaverage
9.19%(from361.11to394.29)
Changeinindex:
6.21%(from15.29to16.24)
Thenumbersdifferbecauseoneisanaverageofstockpricesonaparticulardayandtheotheris
anindexcomparedtoabaseperiodvalue.
5.

Mr.Cromwellsmarketordertobuywouldhavebeenfilledatthelowestpriceavailableatthetime,
whileasellorderwouldhavebeenfilledatthehighestpriceavailableatthattime.However,since
marketordersareexecutedquickly,itisreasonabletoexpectthatMr.Cromwellwouldhavepaid
$5,000forhismarketordertobuyaroundlot(100sharesat$50ashare).
Hewouldalsohaverealized$5,000forhismarketordertosellcommonstock.Ofcourse,wehave
ignoredbrokeragecommissionsandotherincidentalcosts.OntheNYSE,onlyonepriceisquoted,
andbothbuyandsellorderscouldbeexecutedatthatprice.

6.

(a) Theorderwillnotbeexecuted.Thelimitorderwillbeexecutedonlyifthestockpricefallsto
$38orbelow.However,sincetherearetwomoremonthsbeforethelimitorderexpires,itisstill
conceivablethatthestockpricemightfallto$38.
(b) Atapriceof$38pershare,yourbrokerwillbuy100sharesofSallisawToolstockatatotalcost
of$3,800.

Chapter3OnlineInformationandInvesting49

(c) Thisexampleillustratesthatalimitorder,whileeffective,canalsopreventaninvestorfrom
engaginginatransaction.Sincethestockpricedidnotgobelow$38.50,thelimitorderexpired
withoutbeingexecuted.Considerwhatwouldhavehappenedifyouhadboughtthestockat$41
insteadofplacingalimitorder.Youcouldhavesoldthestockfor$47.50pershare,realizinga
profitof$650overthesametimeperiod(i.e.,100sharesat$6.50profitpershare).
7.

Theminimumlossthatyouwouldexperienceinthiscaseis$3.50pershare,or$175,onthetotal
investment(50sharesat$3.50pershare).Itisimportanttorealizethatthisisaminimumloss.Thisis
becausewhenthestockpricefallsto$23,thestoplossorderisconvertedtoamarketordertosellat
thebestpriceavailableatthattime.However,itispossiblethattheactualstockpricemightplunge
downfurther,inwhichcasethestockwouldbesoldbelow$23pershare(possiblyat$20.50inthis
example).Inthiscase,thelosswouldbe$6/share,or$300.00total

8.

Youshouldplaceastoplossordertobuy100sharesat$45.

9.

Sincethestockneverfelltothelimitorderbuyprice,youneverpurchasedit.However,yousolditat
$70pershare,soyouarenowshort100shares.Becausethestockiscurrentlysellingfor$75,your
currentpositionisalossof$500.

10. Itislikelythatyousold500sharesat$30.Itdoesntmatterthatthestockrebounded.Once
thesalewasexecutedyouhadclosedyourpositioninthestock.Thisproblemillustratesthat
althoughyoucanprotectagainstdecliningstockpricesusinglimitorders,therearerisks
involved.
11. Probablynothingwillhappen.Althoughyouplacedalimitordertobuythestock,andthelimitprice
washit,youdidnothaveenoughequityinyouraccounttomakethistransaction.300sharesat$50
persharewouldcost$15,000.Youcouldmakethispurchasewith$7,500inyour50%margin
account,butnotwith$5,000.