Ownership Investments Review Questions & Answers
1.What is the major difference in ownership and loanership investments? List the characteristics of ownership, or equity, investments.
With ownership investments, you actually own a portion, however small or large, of an investment. For example, you could be the single owner of a rental home, or you could own a few shares of a huge corporation or mutual fund worth millions of dollars. Although we may talk about “owning” a bond or government security, in fact, we don’t “own” a portion of the corporation or the government. Bonds and government securities are both examples of loanership, or lending, investments. The investor loans his or her money for an agreed upon return, often with a fixed time period.
Other characteristics of equities include:
2.Given the positive correlation, or relationship, between risk and rate of return, explain the relative earnings of ownership and loanership, or lending, investments.
Ownership investments, which appear higher on the risk pyramid, generally have higher earnings than lending investments that are characterized by lower risk. The average annual returns as reported by the Ibbotson Associates research firm support this investment principle as the average annual returns on stocks exceed that for government bonds or Treasury bills. The higher the risk, the higher the return or the lower the risk, the lower the return.
3.What is one of the biggest risks associated with common stock ownership?
There is no guarantee that an investor will ever receive any or all of the money back for the shares of stock purchased. For example, during the market downturn during 2000 and 2001, the price of some technology stocks declined from over $100 to less than $10 per share. Investors could hold on to those stocks until the prices increase beyond the original purchase price. However, there is no guarantee that the stock will again reach the higher price.
4.Both corporations and consumers make choices about dividends. What are those choices?
When a corporation has a profitable quarter, the profit can be reinvested back into the company for research, development, innovations, or other needs. In this case, none of the profit would be shared with the stockholders in the form of dividends. Other companies might pay dividends consistently (such as utility companies, for example), most of the time, occasionally, or never. Although determined by the board of directors, the choice of whether or not to pay quarterly dividends is also correlated with the type of company represented. For example, a growth stock company might not be expected to pay a dividend while an income stock company would.
Investors can choose to receive dividends in the form of a quarterly check or to reinvest the dividends to purchase additional shares. DRIPs, or dividend reinvestment plans, offer a cheap and easy alternative for purchasing more shares.
5.When reinvesting dividends to purchase additional shares, why must you pay income taxes on this “income” when no money was received?
Although an investor does not directly receive the dividend check to deposit and spend for food, clothing, or other purchases, the investor did receive the income. The DRIP plan is simply a pre-arranged mechanism for “spending “ the dividend income. Thus, the income is subject to federal and state income taxation.
6.Why is it important to learn about a company and its industry? What sources of information might be helpful?
When selecting investments, the adage “buy what you know” is sound advice. Before investing in any company, it is important that you are knowledgeable about the company, the goods or services it provides, and the status of the company within the larger industry. Personal finance magazines such as Kiplinger’s Personal Finance and Money offer insights into the stock market, as well as individual companies, as do major financial newspapers such as The Wall Street Journal or other newspapers available in larger urban markets. Value Line is just one example of a number of investment research and rating publications that can be found in larger libraries. The Internet offers information similar to that found in these print publications; however, be careful that the sites are provided by unbiased sources.
7.What information can be gleaned from the prospectus and annual report for a stock you are considering?
The prospectus includes information on the company management and financial situation at the time the company issued stock. For more current information on the company performance, consult the annual report. Explanations of the company operations are included in the annual report as well as financial statements such as the balance sheet and income statement. From the latter, ratios and other analytical measures are derived for each stock. Although both provide a variety of information about a company, be sure to consult a professional, or other print or Internet references, to get the most recent information available before making an investment decision.
8.Where would you get a prospectus or annual report?
You can acquire a prospectus from a financial services professional or directly from the company. Internet sites for the Securities and Exchange Commission (SEC available at http://www.sec.gov) and the Public Registers Annual Report Service (http://www.prars.com) offer prospectuses for many companies. Annual reports may also be available from a financial professional or directly from the company Internet site or the “shareholder relations” department.
9.List and briefly describe the five major indexes commonly used to report on stock market activity.
Commonly reported market indexes include the:
10.What does beta measure? Why is it an important to know when considering different stock purchases?
Beta is a statistical measure calculated for stocks, mutual funds, and portfolios to measure the volatility, and risk, inherent in an individual security or total portfolio holdings. The average beta for the market is +1; however, betas can range from negative to positive. A larger beta suggests a more volatile, or risky, security or portfolio.
11.Explain the terms earnings per share and price/earnings ratio.
Earnings per share (EPS) reflects the company earnings for each share of common stock outstanding, but not necessarily the level of dividends to be paid. The company chooses whether to pay a dividend to the common stockholders or to reinvest the earnings into company expansion or renovation. The EPS is used to compare the performance of different companies; in other words, how did the level of earnings compare for different companies in the same industry? Which company earned more?
The price/earnings (P/E) ratio is used to compare the actual ratio for a given stock to an assumed, or standard, P/E ratio for that same stock. Although the complexity of P/E ratios is beyond the scope of this unit, the ratios are commonly reported for individual stocks as well as the whole stock market or for the stocks that make up one of the indexes described above. The P/E ratio reflects the amount, or price, that investors are willing to pay for a dollar of company earnings.
12.Explain dollar-cost averaging and a buy and hold strategy. Do these investment strategies work in opposition to each other or do they complement each other?
Implementing a dollar cost averaging strategy (also discussed in Unit 2) requires you to invest the same amount of money, regardless of the price of the security, at the same time interval (e.g., bi-weekly, monthly, or quarterly). A buy and hold strategy is based on the idea that securities are purchased and held for years regardless of the periodic fluctuations in the price. Assuming the securities are chosen after thorough analysis, these strategies work well together. Dollar cost averaging offers the benefit of disciplined investing and a generally lower average cost per share, while a buy and hold strategy helps to reduce taxes and transaction costs and lowers portfolio volatility over time.
13.What is the difference between a bull and bear market?
The term bull market refers to a market that is experiencing higher prices, or increasing value. A bear market describes a period of decreasing prices. An easy way to remember the difference is based on how both animals “attack” or charge. Bulls attack with horns UP, while bears attack with claws DOWN.
14.There are several ways to invest in real estate. List and briefly describe each.
Recall the caveat from Unit 1 regarding the rate of return on real estate and home ownership as an investment. Whereas home ownership is a goal for many people, low appreciation on real estate in some regions suggests that purchasing a home might best be thought of as “buying shelter” and not an investment likely to experience rapid appreciation. As noted in this unit, there are numerous expenses and risks associated with buying, selling and owning real estate. Thus, although home ownership is an investment for the future, and may be a source of retirement income, it is important to differentiate the costs and benefits of investing in a home from the costs and benefits of investing in real estate. Consequently, there are at least four ways to directly or indirectly invest in real estate:
15.What factors contribute to the higher risk associated with real estate as an investment?
Real estate investments fall higher on the investment pyramid because of a number of factors that increase the risk. Some of these factors include:
16.Describe an equity unit investment trust (UIT). What are the advantages and disadvantages of this investment?
An equity UIT is a buy and hold investment designed to generate dividends and capital gains for the “life” of the trust, or the specified holding period. The UIT is an unmanaged portfolio made up of a small, selected group of stocks. The stocks are chosen to represent an investment strategy such as a particular security index, foreign stocks, a sector or industry within the economy, or a geographic region.
Advantages include (1) targeted diversification, (2) stable portfolio holdings that contribute to (3) high tax efficiency (no capital gains are generated), and what some consider to be (4) low cost (typically a $1,000 per unit). Because there is no professional management, there are (5) no worries about management changes or management fees. Although some of the advantages might be considered to be disadvantages by some, a true disadvantage is the relatively high front-end load of about 3% of the amount invested.
17.What is a mutual fund? Review the list of ten categories, or options, for equity mutual funds. Identify three investment objectives or classifying characteristics that could be used to group the ten options listed.
A mutual fund is a diversified portfolio of securities chosen on the basis of an identified investment objective or strategy. Professional management of the portfolio is a commonly cited advantage. Of the ten equity mutual fund categories listed, they might be broadly grouped around three distinct classifications:
18.List the advantages and disadvantages of investing in collectibles.
Whereas collectibles are often cited as an investment, it is important to differentiate the true investment value from the psychic value, or pleasure gained from the collection. Aside from the pleasure derived, and the potential for gain on the sale, collectibles are characterized by a longer list of disadvantages:
19.What are some of the caveats to remember when purchasing a business, starting your own business, or purchasing a business franchise as an investment?
Small business investments represent an extremely high risk because of their high failure rate. A business plan that considers financing, cash flow, and reserves is essential. The plan should clearly separate the household and business budgets and assets, so that the family, or household, financial situation is not put at risk. Public and private sources can provide assistance and should be only one step in the research process conducted prior to starting a business as an investment.
20.Commodities, like collectibles, require an investor who is knowledgeable of the product, the associated markets, the buyers, and the high risk and potential for loss. And, like collectibles, the expert advice often is “just don’t do it.” Why?
Commodities, including products such as meat, grains, coffee, sugar, cocoa, fuel oil, and other basic necessities, are found at the very peak of the investment pyramid because of the extreme risk, and potential for loss, associated with this investment. As noted, it is estimated that only a very small percentage of the investors who speculate in commodities make a profit. The key word here is speculating or the holding of an asset for which supply and demand determines the price. No other income is generated by the investment. Speculating is not investing – whether the product is commodities or collectibles. With investing, the asset generates some return on income, in addition to any change in value, up or down, influenced by the market and the economy.
21.What is the “Rule of Three” in reference to investing?
Brokers, and other financial professionals, provide different levels of assistance and advice with investment decisions in exchange for a commission, which also varies widely. The Rule of Three reminds you to check the cost of buying and selling with at least three firms before making your choice. For example, full-service brokers provide more assistance and service in exchange for a higher commission structure than discount brokers who will simply execute a trade for lower commission.
22.In addition to consulting a broker or other financial professional to buy or sell equities, name three other approaches.
When purchasing or selling equities, you might consider the following options:
23.Successful investors build a portfolio on the critical tenet of diversification. Which of the equity investments discussed in this unit offer “immediate” diversification?
Mutual funds, real estate limited partnerships, REITs, and UITs offer limited immediate diversification with the investment purchase. However, this diversification is still very limited to a group of companies that fit the mutual fund or UIT objective or the multiple pieces of property owned by the limited partnership or REIT. Although this is one type of diversification, a much broader spectrum of securities would be necessary to develop a fully diversified portfolio to accomplish your planned asset allocation.