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From: lott@investfaq.com (Christopher Lott)
Newsgroups: misc.invest.misc,misc.invest.stocks,misc.invest.technical,misc.invest.options,misc.answers,news.answers
Subject: The Investment FAQ (part 2 of 19)
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ReplyTo: lott at investfaq dot com
Summary: Answers to frequently asked questions about investments.
Should be read by anyone who wishes to post to misc.invest.*
Organization: The Investment FAQ publicity department
Keywords: invest, finance, stock, bond, fund, broker, exchange, money, FAQ
URL: http://investfaq.com/
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Archivename: investmentfaq/general/part2
Version: $Id: part02,v 1.58 2002/08/14 10:20:04 lott Exp lott $
Compiler: Christopher Lott, lott at investfaq dot com
The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance. This is a plaintext
version of The Investment FAQ, part 2 of 19. The web site
always has the latest version, including inline links. Please browse
http://investfaq.com/
Terms of Use
The following terms and conditions apply to the plaintext version of
The Investment FAQ that is posted regularly to various newsgroups.
Different terms and conditions apply to documents on The Investment
FAQ web site.
The Investment FAQ is copyright 2001 by Christopher Lott, and is
protected by copyright as a collective work and/or compilation,
pursuant to U.S. copyright laws, international conventions, and other
copyright laws. The contents of The Investment FAQ are intended for
personal use, not for sale or other commercial redistribution.
The plaintext version of The Investment FAQ may be copied, stored,
made available on web sites, or distributed on electronic media
provided the following conditions are met:
+ The URL of The Investment FAQ home page is displayed prominently.
+ No fees or compensation are charged for this information,
excluding charges for the media used to distribute it.
+ No advertisements appear on the same web page as this material.
+ Proper attribution is given to the authors of individual articles.
+ This copyright notice is included intact.
Disclaimers
Neither the compiler of nor contributors to The Investment FAQ make
any express or implied warranties (including, without limitation, any
warranty of merchantability or fitness for a particular purpose or
use) regarding the information supplied. The Investment FAQ is
provided to the user "as is". Neither the compiler nor contributors
warrant that The Investment FAQ will be error free. Neither the
compiler nor contributors will be liable to any user or anyone else
for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.
Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly. Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it. Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
information given in other answers. Readers outside the USA can reach
US800 telephone numbers, for a charge, using a service such as MCI's
Call USA. All prices are listed in US dollars unless otherwise
specified.
Please send comments and new submissions to the compiler.
Check http://investfaq.com/ for updates
Subject: Advice  Beginning Investors
LastRevised: 1 Aug 1998
ContributedBy: Steven Pearson, E. Green, Chris Lott ( contact me )
Investing is just one aspect of personal finance. People often seem to
have the itch to try their hand at investing before they get the rest of
their act together. This is a big mistake. For this reason, it's a
good idea for "new investors" to hit the library and read maybe three
different overall guides to personal finance  three for different
perspectives, and because common themes will emerge (repetition implies
authority?). Personal finance issues include making a budget, sticking
to a budget, saving money towards major purchases or retirement,
managing debt appropriately, insuring your property, etc. Appropriate
books that focus on personal finance include the following (the links
point to Amazon.com):
* Janet Bamford et al.
The Consumer Reports Money Book: How to Get It, Save It, and Spend
It Wisely (3rd edn)
* Andrew Tobias
The Only Investment Guide You'll Ever Need
* Eric Tyson
Personal Finance for Dummies
Another great resource for learning about investing, insurance, stocks,
etc. is the Wall Street Journal's Section C front page. Beginners
should make a special effort to get the Friday edition of the WSJ
because a column named "Getting Going" usually appears on that day and
discusses issues in, well, getting going on investments. If you don't
want to spend the dollar or so for the WSJ, try your local library.
What I am specifically NOT talking about is most anything that appears
on a list of investing/stock market books that are posted in
misc.invest.* from time to time. This includes books like Market Logic,
One Up on Wall Street, Beating the Dow, Winning on Wall Street, The
Intelligent Investor, etc. These are not general enough. They are
investment books, not personal finance books.
Many "beginning investors" have no business investing in stocks. The
books recommended above give good overall money management, budgeting,
purchasing, insurance, taxes, estate issues, and investing backgrounds
from which to build a personal framework. Only after that should one
explore particular investments. If someone needs to unload some cash in
the meantime, they should put it in a money market fund, or yes, even a
bank account, until they complete their basic training.
While I sympathize with those who view this education as a daunting
task, I don't see any better answer. People who know next to nothing
and always depend on "professional advisors" to handhold them through
all transactions are simply sheep asking to be fleeced (they may not
actually be fleeced, but most of them will at least get their tails
bobbed). In the long run, an individual is the only person ultimately
responsible for his or her own financial situation.
Beginners may want to look further in The Investment FAQ for the
articles that discuss the basics of mutual funds , basics of stocks ,
and basics of bonds . For more indepth material, browse the Investment
FAQ bookshelf with its recommended books about personal finance and
investments.
Check http://investfaq.com/ for updates
Subject: Advice  Buying a Car at a Reasonable Price
LastRevised: 1 Aug 2001
ContributedBy: Kyle Busch (kbusch at velocity.net)
Before making a purchase, especially a large one, most buyers ponder an
equation that goes something like: What is it going to cost me, and will
that equal what I am going to get?
Consider that equation when buying your next vehicle. Naturally, you
want to get the most vehicle for the money you spend. Here are several
tips that will help you to get more for your money.
First, and foremost, consider eliminating some of the steep depreciation
cost incurred during the first three years of vehicle ownership by
purchasing a 2 to 3 yearold used vehicle.
The price can be further reduced by paying cash. However, if you need
to finance your next vehicle purchase, consider doing the following to
keep its cost closer to the "as if you were paying cash" figure.
* Take the time to carefully identify your current and your future
transportation needs, and choose an appropriate
vehicle.Transportation represents different things to different
people. For some drivers, it represents status in society. Other
drivers place greater emphasis on reliably just getting from point
A to points B and C. The more closely that you match your driving
needs with the vehicle you buy, the more driving pleasure you will
experience and the more likely you will want to hold on to the
vehicle.
If you can't fully identify your transportation needs or the
vehicle that can best satisfy them, consult the April issue of
Consumer Reports at a public library. The publication groups
vehicles into categories, provides frequencyofrepair information
for many vehicles, and gives vehicle price information. It is a
good idea to identify 2 or 3 vehicles in a particular category that
meet your transportation needs.This enables some latitude when
shopping for the vehicle. =
* Identify how much you can afford to spend per month on
transportation. A rule of thumb suggests that the cost to rent an
apartment per month should not be greater than 25 percent of your
monthly net pay.The cost of an auto loan should not exceed 10 to 12
percent of your monthly net pay. In some instances, leasing a
vehicle could be a better option than taking out a loan.
* The vehicle down payment should be the largest possible, and the
amount of money borrowed the lowest possible. In addition,
borrowing money for the shortest period of time (i.e., a 24month
loan rather than a 48month loan) will reduce the overall cost of
the loan.
* Identify the various loan sources such as banks, savings and loans,
credit unions, and national lenders (i.e., go online to ask
jeeves.com and specify "automobile financing sources"). In regard
to national financing vs. local financing, it can be useful to
determine what the cost of a loan would be from the national
sources, but accept a loan from a local source if the loan cost is
comparable or nearly comparable between the two. Compare the APR
(annual percentage rate) that each of the sources will charge for
the loan. The cost of a loan is negotiable. Therefore, be certain
to inform each source what the others have to offer. In addition
to the loan's APR, remember to also compare the other costs
associated with a loan, such as loan insurance and loan processing
costs.
* Be certain to read and understand any fine print contained in the
loan contract. Insist that the loan contract gives you the option
of making payments early and that the payments will be applied on
the loan principle with no penalty or extra cost if you payoff the
loan early.
* Do not settle for a vehicle that does not entirely meet your
transportation needs because of low dealer or manufacturer
incentive financing.Sometimes dealers or manufactures offer
extremely low APR financing on vehicles that the dealer is having a
hard time selling. That's why it helps to have initially
identified the correct vehicle before encountering the sales
pitches and other influences of buying a vehicle. Kyle Busch is
the author of Drive the Best for the Price: How to Buy a Used
Automobile, SportUtility Vehicle, or Minivan and Save Money . To find
out more about the author and this book visit:
http://www.drivethebestbook.com
Check http://investfaq.com/ for updates
Subject: Advice  Errors in Investing
LastRevised: 2 Aug 1999
ContributedBy: Chris Lott ( contact me ), Thomas Price (tprice at
engr.msstate.edu)
The Wall Street Journal of June 18, 1991 had an article on pages C1/C10
on Investment Errors and how to avoid them. As summarized from that
article, the errors are:
* Not following an investment objective when you build a portfolio.
* Buying too many mutual funds.
* Not researching a oneproduct stock before you buy.
* Believing that you can pick market highs and lows (time the
market).
* Taking profits early.
* Not cutting your losses.
* Buying the hottest {stock, mutual fund} from last year.
Here's a recent quote that underscores the last item. When asked
"What's the biggest mistake individual investors make?" on Wall $treet
Week, John Bogle, founder and senior chairman of Vanguard mutual funds,
said "Extrapolating the trend" or buying the hot stock.
On a final note, get this quote on market timing:
In the 1980s if you were out of the market on the ten best
trading days of the decade you missed onethird of the total
return.
Check http://investfaq.com/ for updates
Subject: Advice  Using a FullService Broker
LastRevised: 23 Mar 1998
ContributedBy: Bill Rini (bill at moneypages.com), Chris Lott ( contact
me )
There are several reasons to choose a fullservice broker over a
discount or web broker. People use a fullservice broker because they
may not want to do their own research, because they are only interested
in longterm investing, because they like to hear the broker's
investment ideas, etc. But another important reason is that not
everybody likes to trade. I may want retirement planning services from
my broker. I may want to buy 3 or 4 mutual funds and have my broker
worry about them. If my broker is a financial planner, perhaps I want
tax or estate advice on certain investment options. Maybe I'm saving
for my newborn child's education but I have no idea or desire to work
out a plan to make sure the money is there when she or he needs it.
A huge reason to stick with a fullservice broker is access to initial
public offerings (IPOs). These are generally reserved for the very best
clients, where best is defined as "someone who generates lots of
revenue," so someone who trades just a few times a year doesn't have a
chance. But if you can afford to trade frequently at the fullservice
commission rates, you may be favored with access to some great IPOs.
And the real big one for a lot of people is quite simply time . Full
service brokerage clients also tend to be higher net worth individuals
as well. If I'm a doctor or lawyer, I can probably make more money by
focusing on my business than spending it researching stocks. For many
people today, time is a more valuable commodity than money. In fact, it
doesn't even have to do with how wealthy you are. Americans, in
general, work some pretty insane hours. Spending time researching
stocks or staying up on the market is quality time not spent with
family, friends, or doing things that they enjoy. On the other hand
some people enjoy the market and for those people there are discount
brokers.
The one thing that sort of scares me about the difference between full
service and discount brokers is that a pretty good chunk of discount
brokerage firm clients are not that educated about investing. They look
at a $20 commission (discount broker) and a $50 commission (full service
broker) and they decide they can't afford to invest with a full service
broker. Instead they plow their life savings into some wonder stock
they heard about from a friend (hey, it's only a $20 commission, why
not?) and lose a few hundred or thousand bucks when the investment goes
south. Not that a broker is going to pick winners 100% of the time but
at least the broker can guide or mentor a beginning investor until they
learn enough to know what to look for and what not to look for in a
stock. I look at the $30 difference in what the two types of brokerage
firms charge as the rebate for education and doing my own research. If
you're not going to educate yourself or do your own research, you don't
deserve the rebate.
Check http://investfaq.com/ for updates
Subject: Advice  OneLine Wisdom
LastRevised: 22 Aug 1993
ContributedBy: Maurice Suhre
This is a collection of oneline pieces of investment wisdom, with brief
explanations. Use and apply at your own risk or discretion. They are
not in any particular order.
Hang up on cold calls.
While it is theoretically possible that someone is going to offer
you the opportunity of a lifetime, it is more likely that it is
some sort of scam. Even if it is legitimate, the caller cannot
know your financial position, goals, risk tolerance, or any other
parameters which should be considered when selecting investments.
If you can't bear the thought of hanging up, ask for material to be
sent by mail.
Don't invest in anything you don't understand.
There were horror stories of people who had lost fortunes by being
short puts during the 87 crash. I imagine that they had no idea of
the risks they were taking. Also, all the complaints about penny
stocks, whether fraudulent or not, are partially a result of not
understanding the risks and mechanisms.
If it sounds too good to be true, it probably is [too good to be true].
Also stated as ``There ain't no such thing as a free lunch
(TANSTAAFL).'' Remember, every investment opportunity competes with
every other investment opportunity. If one seems wildly better
than the others, there are probably hidden risks or you don't
understand something.
If your only tool is a hammer, every problem looks like a nail.
Someone (possibly a financial planner) with a very limited
selection of products will naturally try to jam you into those
which s/he sells. These may be less suitable than other products
not carried.
Don't rush into an investment.
If someone tells you that the opportunity is closing, filling up
fast, or in any other way suggests a time pressure, be very leery.
Very low priced stocks require special treatment.
Risks are substantial, bid/asked spreads are large, prices are
volatile, and commissions are relatively high. You need a broker
who knows how to purchase these stocks and dicker for a good price.
Check http://investfaq.com/ for updates
Subject: Advice  Paying for Investment Advice
LastRevised: 25 Apr 1997
ContributedBy: Chris Lott ( contact me )
I'm no expert, but there's a simple rule that you should use to evaluate
all advice that is offered to you, especially advice for which someone
who doesn't know you is asking significant sums of money. Ask yourself
why the person is selling or giving it to you. If it sounds like a sure
ticket to riches, then why is the person wasting their time on YOU when
they could be out there making piles of dough?
Of course I'm offering advice here in this article, so let's turn the
tables on me right now. What's in it for me? Well, if you're reading
this article from my web site, look up at the top of the page. If you
have images turned on, you'll see a banner ad. I get a tiny payment
each time a person loads one of my pages with an ad. So my motivation
is to provide informative articles in order to lure visitors to the
site. Of course if you're reading this from the plaintext version of
the FAQ, you won't see any ads, but please do stop by the site sometime!
;)
So if someone promises you advice that will yield 1020% monthly
returns, perhaps at a price of some $3,000, you should immediately get
suspicious. If this were really true  i.e., if you pay for the advice
you'll immediately start getting these returns  you would be making
over 300% annually (compounded). Hey, that would sure be great, I
wouldn't have a day job anymore. And if it were true, wouldn't you
think that the person trying to sell it to you would forget all about
selling and just watch his or her money triple every year? But they're
not doing that, which should give you a pretty good idea about where the
money's being made, namely from you .
I'm not trying to say that you should never pay for advice, just that
you should not overpay for advice. Some advice, especially the sort
that comes from $15 books on personal finance and investments can easily
be worth ten times that sum. Advice from your CPA or tax advisor will
probably cost you a 3 or even 4digit figure, but since it's specialized
to your case and comes from a professional, that's probably money well
spent.
It seems appropriate to close this article with a quote that I learned
from Robert Heinlein books, but it's probably older than that:
TANSTAAFL  there ain't no such thing as a free lunch.
Check http://investfaq.com/ for updates
Subject: Advice  Researching a Company
LastRevised: 3 Jun 1997
ContributedBy: George Regnery (regnery at yahoo.com)
This article gives a basic idea of some steps that you might take to
research a company. Many sites on the web will help you in your quest
for information, and this article gives a few of them. You might look
for the following.
1. What multiple of earnings is the company trading at versus other
companies in the industry? The site http://www.stocksmart.com does
this comparison reasonably well, and they base it on forward
earnings instead of historical earnings, which is also good.
2. Is the stock near a high or low, and how has it done recently.
This is usually considered technical analysis. More sophisticated
(or at least more complicated) studies can also be performed.
There are several sites that will give you historical graphs; one
is Yahoo. http://biz.yahoo.com/r/
3. When compared with other companies in the industry, how much times
the book value or times sales is the company trading? For this
information, the site http://www.marketguide.com is a good place to
start.
4. Does the company have good products, good management, good future
prospects? Are they being sued? Do they have patents? What's the
competition like? Do they have long term contracts established? Is
their brand name recognized? Depending on the industry, some or all
of these questions may be relevant. There isn't a simple web site
for this information, of course. The Hoover's profiles have some
limited information to at least let you get a feel for the basics
of the company. And the SEC has lots of information in their Edgar
databank.
5. Management. Does the company have competent people running it? The
backgrounds of the directors can be found in proxy statements
(14As) in the Edgar database. Note that proxies are written by the
companies, though. Another thing I would suggest looking at is the
compensation structure of the CEO and other top management. Don't
worry so much about the raw figure of how they are paid  instead,
look to see how that compensation is structured. If the management
gets a big base but bonuses are a small portion, look carefully at
the company. For some industries, like electric utilities, this is
OK, because the management isn't going to make a huge difference
(utilities are highly regulated, and thus the management is
preventing from making a lot of decisions). However, in a high
tech industry, or many other industries, watch your step if the
mgmt. gets a big base and the bonus is insignificant. This means
that they won't be any better off financially if the company makes
a lot of profits vs. no profits (unless, of course, they own a lot
of stock). This information is all in the Proxies at the SEC.
Also check to see if the company has a shareholder rights plan,
because if they do, the management likely doesn't give a damn about
shareholder rights, but rather cares about their own jobs. (These
plans are commonly used to defend against unfriendly takeovers and
therefore provide a safety blanket for management.) These
suggestions should get you started. Also check the article elsewhere in
this FAQ on free information sources for more resources away from the
web.
Check http://investfaq.com/ for updates
Subject: Advice  Target Stock Prices
LastRevised: 25 Jun 2000
ContributedBy: Uncle Arnie (blash404 at aol.com)
A target price for a stock is a figure published by a securities
industry person, usually an analyst. The idea is that the target price
is a prediction, a guess about where the stock is headed. Target prices
usually are associated with a date by which the stock is expected to hit
the target. With that explanation out of the way..
Why do people suddenly think that the term du jour "target price" has
any meaning?? Consider the sources of these numbers. They're ALWAYS
issued by someone who has a vested interest in the issue: It could be an
analyst whose firm was the underwriter, it could be an analyst whose
firm is brownnosing the company, it could be a firm with a large
position in the stock, it could be an individual trying to talk the
stock up so he can get out even, or it could be the "pump" segment of a
pumpanddump operation. There is also a chance that the analyst has no
agenda and honestly thinks the stock price is really going places. But
in all too many cases it's nothing more than wishful guesswork (unless
they have a crystal ball that works), so the advice here: ignore target
prices, especially ones for internet companies.
Check http://investfaq.com/ for updates
Subject: Analysis  Annual Reports
LastRevised: 31 Oct 1995
ContributedBy: Jerry Bailey, Chris Lott ( contact me )
The June 1994 Issue of "Better Investing" magazine, page 26 has a
threepage article about reading and understanding company annual
reports. I will paraphrase:
1. Start with the notes and read from back to front since the front is
management fluff.
2. Look for litigation that could obliterate equity, a pension plan in
sad shape, or accounting changes that inflated earnings.
3. Use it to evaluate management. I only read the boring things of
the companies I am holding for long term growth. If I am planning
a quick in and out, such as buying depressed stocks like BBA, CML,
CLE, etc.), I don't waste my time.
4. Look for notes to offer relevant details; not "selected" and
"certain" assets. Revenue and operating profits of operating
divisions, geographical divisions, etc.
5. How the company keeps its books, especially as compared to other
companies in its industry.
6. Inventory. Did it go down because of a different accounting
method?
7. What assets does the company own and what assets are leased?
If you do much of this, I really recommend just reading the article.
The following list of resources may also help.
* John A. Tracy has written an an easytoread and informative book
named How to Read a Financial Report (4th edn., Wiley, 1993). This
book should give you a good start. You won't become a graduate
student in finance by reading it, but it will certainly help you
grasp the nuts and bolts of annual reports.
* ABC News offers the following article:
http://abcnews.go.com/sections/business/Finance/startstocks4.html
* IBM offers a web site with much information about understanding
financial reports:
http://www.ibm.com/FinancialGuide/
Check http://investfaq.com/ for updates
Subject: Analysis  Beta and Alpha
LastRevised: 22 Oct 1997
ContributedBy: Ajay Shah ( www.igidr.ac.in/~ajayshah ), R. Shukla
(rkshukla at som.syr.edu), Bob Pierce (rbp at investor.pgh.pa.us)
Beta is the sensitivity of a stock's returns to the returns on some
market index (e.g., S&P 500). Beta values can be roughly characterized
as follows:
* b less than 0
Negative beta is possible but not likely. People thought gold
stocks should have negative betas but that hasn't been true.
* b equal to 0
Cash under your mattress, assuming no inflation
* beta between 0 and 1
Lowvolatility investments (e.g., utility stocks)
* b equal to 1
Matching the index (e.g., for the S&P 500, an index fund)
* b greater than 1
Anything more volatile than the index (e.g., small cap. funds)
* b much greater than 1 (tending toward infinity)
Impossible, because the stock would be expected to go to zero on
any market decline. 23 is probably as high as you will get.
More interesting is the idea that securities MAY have different betas in
up and down markets. Forbes used to (and may still) rate mutual funds
for bull and bear market performance.
Alpha is a measure of residual risk (sometimes called "selecting risk")
of an investment relative to some market index. For all the gory
details on Alpha, please see a book on technical analysis.
Here is an example showing the inner details of the beta calculation
process:
Suppose we collected endofthemonth prices and any dividends for a
stock and the S&P 500 index for 61 months (0..60). We need n + 1 price
observations to calculate n holding period returns, so since we would
like to index the returns as 1..60, the prices are indexed 0..60. Also,
professional beta services use monthly data over a five year period.
Now, calculate monthly holding period returns using the prices and
dividends. For example, the return for month 2 will be calculated as:
r_2 = ( p_2  p_1 + d_2 ) / p_1
Here r denotes return, p denotes price, and d denotes dividend. The
following table of monthly data may help in visualizing the process.
(Monthly data is preferred in the profession because investors' horizons
are said to be monthly.)
Nr. Date Price Div.(*) Return
0 12/31/86 45.20 0.00 
1 01/31/87 47.00 0.00 0.0398
2 02/28/87 46.75 0.30 0.0011
. ... ... ... ...
59 11/30/91 46.75 0.30 0.0011
60 12/31/91 48.00 0.00 0.0267
(*) Dividend refers to the dividend paid during the period. They are
assumed to be paid on the date. For example, the dividend of 0.30 could
have been paid between 02/01/87 and 02/28/87, but is assumed to be paid
on 02/28/87.
So now we'll have a series of 60 returns on the stock and the index
(1...61). Plot the returns on a graph and fit the bestfit line
(visually or using some least squares process):
 * /
stock  * * */ *
returns * * / *
 * / *
 * /* * *
 / * *
 / *


+ index returns
The slope of the line is Beta. Merrill Lynch, Wells Fargo, and others
use a very similar process (they differ in which index they use and in
some econometric nuances).
Now what does Beta mean? A lot of disservice has been done to Beta in
the popular press because of trying to simplify the concept. A beta of
1.5 does not mean that is the market goes up by 10 points, the stock
will go up by 15 points. It doesn't even mean that if the market has a
return (over some period, say a month) of 2%, the stock will have a
return of 3%. To understand Beta, look at the equation of the line we
just fitted:
stock return = alpha + beta * index return
Technically speaking, alpha is the intercept in the estimation model.
It is expected to be equal to riskfree rate times (1  beta). But it
is best ignored by most people. In another (very similar equation) the
intercept, which is also called alpha, is a measure of superior
performance.
Therefore, by computing the derivative, we can write:
Change in stock return = beta * change in index return
So, truly and technically speaking, if the market return is 2% above its
mean, the stock return would be 3% above its mean, if the stock beta is
1.5.
One shot at interpreting beta is the following. On a day the (S&Ptype)
market index goes up by 1%, a stock with beta of 1.5 will go up by 1.5%
+ epsilon. Thus it won't go up by exactly 1.5%, but by something
different.
The good thing is that the epsilon values for different stocks are
guaranteed to be uncorrelated with each other. Hence in a diversified
portfolio, you can expect all the epsilons (of different stocks) to
cancel out. Thus if you hold a diversified portfolio, the beta of a
stock characterizes that stock's response to fluctuations in the market
portfolio.
So in a diversified portfolio, the beta of stock X is a good summary of
its risk properties with respect to the "systematic risk", which is
fluctuations in the market index. A stock with high beta responds
strongly to variations in the market, and a stock with low beta is
relatively insensitive to variations in the market.
E.g. if you had a portfolio of beta 1.2, and decided to add a stock
with beta 1.5, then you know that you are slightly increasing the
riskiness (and average return) of your portfolio. This conclusion is
reached by merely comparing two numbers (1.2 and 1.5). That parsimony
of computation is the major contribution of the notion of "beta".
Conversely if you got cold feet about the variability of your beta = 1.2
portfolio, you could augment it with a few companies with beta less than
1.
If you had wished to figure such conclusions without the notion of beta,
you would have had to deal with large covariance matrices and nontrivial
computations.
Finally, a reference. See Malkiel, A Random Walk Down Wall Street , for
more information on beta as an estimate of risk.
Here are a few links that offer information about beta.
* Barra Inc. offers historical and predicted beta values for stocks
that make up the major indexes. Visit this URL:
http://www.Barra.COM/MktIndices/default.asp
* For a brief discussion of using Beta and Alpha values to pick
stocks, visit this URL:
http://sunflower.singnet.com.sg/~midaz/Select1.htm
Check http://investfaq.com/ for updates
Subject: Analysis  BooktoBill Ratio
LastRevised: 19 Aug 1993
ContributedBy: Timothy May
The booktobill ration is the ratio of business "booked" (orders taken)
to business "billed" (products shipped and bills sent).
A booktobill of 1.0 implies incoming business = outgoing product.
Often in downturns, the btb drops to 0.9, sometimes even lower. A
btb of 1.1 or higher is very encouraging.
Check http://investfaq.com/ for updates
Subject: Analysis  Book Value
LastRevised: 23 Mar 1998
ContributedBy: Art Kamlet (artkamlet at aol.com)
In simplest terms, Book Value is Assets less Liabilities.
The problem is Assets includes, as stated, existing land & buildings,
inventory, cash in the bank, etc. held by the company.
The problem in assuming you can sell off these assets and receive their
listed value is that such values are accounting numbers, but otherwise
pretty unrealistic.
Consider a company owning a 40 year old building in downtown Chicago.
That building might have been depreciated fully and is carried on the
books for $0, while having a resale value of millions. The book value
grossly understates the selloff value of the company.
On the other hand, consider a fastchanging industry with 4yearold
computer equipment which has a few more years to go before being fully
depreciated, but that equipment couldn't be sold for even 10 cents on
the dollar. Here the book value overstates the selloff value.
So consider book value to be assets less liabilities, which are just
numbers, not real items. If you want to know how much a company should
be sold off for, hire a good investment banker, which is often done on
takeover bids.
Check http://investfaq.com/ for updates
Subject: Analysis  Computing Compound Return
LastRevised: 30 Dec 1995
ContributedBy: Paul Randolph (paulr22 at juno dot com)
To calculate the compounded return on an investment, just figure out the
factor by which the original investment multiplied. For example, if
$1000 became $3200 in 10 years, then the multiplying factor is 3200/1000
or 3.2. Now take the 10th root of 3.2 (the multiplying factor) and you
get a compounded return of 1.1233498 (12.3% per year). To see that this
works, note that 1.1233498 ** 10 = 3.2 (i.e., 1.233498 raised to the
10th power equals 3.2).
Here is another way of saying the same thing. This calculation assumes
that all gains are reinvested, so the following formula applies:
TR = (1 + AR) ** YR
where TR is total return (present value/initial value), AR is the
compound annualized return, and YR is years. The symbol '**' is used to
denote exponentiation (2 ** 3 = 8).
To calculate annualized return, the following formula applies:
AR = (TR ** (1/YR))  1
Thus a total return of 950% in 20 years would be equivalent to an
annualized return of 11.914454%. Note that the 950% includes your
initial investment of 100% (by definition) plus a gain of 850%.
For those of you using spreadsheets such as Excel, you would use the
following formula to compute AR for the example discussed above (the
common computer symbol used to denote exponentiation is the caret or hat
on top of the 6).
= TR ^ (1 / YR)  1
where TR = 9.5 and YR = 20. If you want to be creative and have AR
recalculated every time you open your file, you can substitute something
like the following for YR:
( (*cell*  TODAY() ) / 365)
Of course you will have to replace '*cell*' by the appropriate address
of the cell that contains the date on which you bought the security.
Check http://investfaq.com/ for updates
Subject: Analysis  Future and Present Value of Money
LastRevised: 28 Jan 1994
ContributedBy: Chris Lott ( contact me )
This note explains briefly two concepts concerning the
timevalueofmoney, namely future and present value. Careful
application of these concepts will help you evaluate investment
opportunities such as real estate, life insurance, and many others.
Future Value
Future value is simply the sum to which a dollar amount invested today
will grow given some appreciation rate.
To compute the future value of a sum invested today, the formula for
interest that is compounded monthly is:
fv = principal * [ (1 + rrate/12) ** (12 * termy) ]
where
fv = future value
principal = dollar value you have now
termy = term, in years
rrate = annual rate of return in decimal (i.e., use .05 for
5%)
Note that the symbol '**' is used to denote exponentiation (2 ** 3 = 8).
For interest that is compounded annually, use the formula:
fv = principal * [ (1 + rrate) ** (termy) ]
Example:
I invest 1,000 today at 10% for 10 years compounded monthly.
The future value of this amount is 2707.04.
Note that the formula for future value is the formula from Case 1 of
present value (below), but solved for the futuresum rather than the
present value.
Present Value
Present value is the value in today's dollars assigned to an amount of
money in the future, based on some estimate rateofreturn over the
longterm. In this analysis, rateofreturn is calculated based on
monthly compounding.
Two cases of present value are discussed next. Case 1 involves a single
sum that stays invested over time. Case 2 involves a cash stream that
is paid regularly over time (e.g., rent payments), and requires that you
also calculate the effects of inflation.
Case 1a: Present value of money invested over time.
This tells you what a future sum is worth today, given some rate of
return over the time between now and the future. Another way to
read this is that you must invest the present value today at the
rateofreturn to have some future sum in some years from now (but
this only considers the raw dollars, not the purchasing power).
To compute the present value of an invested sum, the formula for
interest that is compounded monthly is:
futuresum
pv = 
(1 + rrate/12) ** (12 * termy)
where
* futuresum = dollar value you want to have in termy
years
* termy = term, in years
* rrate = annual rate of return that you can expect,
in decimal
Example:
I need to have 10,000 in 5 years. The present value of
10,000 assuming an 8% monthly compounded rateofreturn
is 6712.10. I.e., 6712 will grow to 10k in 5 years at
8%.
Case 1b: Effects of inflation
This formulation can also be used to estimate the effects of
inflation; i.e., compute the real purchasing power of present and
future sums. Simply use an estimated rate of inflation instead of
a rate of return for the rrate variable in the equation.
Example:
In 30 years I will receive 1,000,000 (a megabuck). What
is that amount of money worth today (what is the buying
power), assuming a rate of inflation of 4.5%? The answer
is 259,895.65
Case 2: Present value of a cash stream.
This tells you the cost in today's dollars of money that you pay
over time. Usually the payments that you make increase over the
term. Basically, the money you pay in 10 years is worth less than
that which you pay tomorrow, and this equation lets you compute
just how much less.
In this analysis, inflation is compounded yearly. A reasonable
estimate for longterm inflation is 4.5%, but inflation has
historically varied tremendously by country and time period.
To compute the present value of a cash stream, the formula is:
month=12 * termy paymt * (1 + irate) ** int ((month  1)/
12)
pv = SUM

month=1 (1 + rrate/12) ** (month  1)
where
* pv = present value
* SUM (a.k.a. sigma) means to sum the terms on the
righthand side over the range of the variable
'month'; i.e., compute the expression for month=1,
then for month=2, and so on then add them all up
* month = month number
* int() = the integral part of the number; i.e., round
to the closest whole number; this is used to compute
the year number from the month number
* termy = term, in years
* paymt = monthly payment, in dollars
* irate = rate of inflation (increase in
payment/year), in decimal
* rrate = rate of return on money that you can expect,
in decimal
Example:
You pay $500/month in rent over 10 years and estimate
that inflation is 4.5% over the period (your payment
increases with inflation.) Present value is 49,530.57
Two small C programs for computing future and present value are
available. See the article Software  Archive of InvestmentRelated
Programs in this FAQ for more information.
Check http://investfaq.com/ for updates
Subject: Analysis  Goodwill
LastRevised: 18 Jul 1993
ContributedBy: John Keefe
Goodwill is an asset that is created when one company acquires another.
It represents the difference between the price the acquiror pays and the
"fair market value" of the acquired company's assets. For example, if
JerryCo bought Ford Motor for $15 billion, and the accountants
determined that Ford's assets (plant and equipment) were worth $13
billion, $2 billion of the purchase price would be allocated to goodwill
on the balance sheet. In theory the goodwill is the value of the
acquired company over and above the hard assets, and it is usually
thought to represent the value of the acquired company's "franchise,"
that is, the loyalty of its customers, the expertise of its employees;
namely, the intangible factors that make people do business with the
company.
What is the effect on book value? Well, book value usually tries to
measure the liquidation value of a company  what you could sell it for
in a hurry. The accountants look only at the fair market value of the
hard assets, thus goodwill is usually deducted from total assets when
book value is calculated.
For most companies in most industries, book value is next to
meaningless, because assets like plant and equipment are on the books at
their old historical costs, rather than current values. But since it's
an easy number to calculate, and easy to understand, lots of investors
(both professional and amateur) use it in deciding when to buy and sell
stocks.
Check http://investfaq.com/ for updates
Subject: Analysis  Internal Rate of Return (IRR)
LastRevised: 25 June 1999
ContributedBy: Christopher Yost (cpy at world.std.com), Rich Carreiro
(rlcarr at animato.arlington.ma.us)
If you have an investment that requires and produces a number of cash
flows over time, the internal rate of return is defined to be the
discount rate that makes the net present value of those cash flows equal
to zero. This article discusses computing the internal rate of return
on periodic payments, which might be regular payments into a portfolio
or other savings program, or payments against a loan. Both scenarios
are discussed in some detail.
We'll begin with a savings program. Assume that a sum "P" has been
invested into some mutual fund or like account and that additional
deposits "p" are made to the account each month for "n" months. Assume
further that investments are made at the beginning of each month,
implying that interest accrues for a full "n" months on the first
payment and for one month on the last payment. Given all this data, how
can we compute the future value of the account at any month? Or if we
know the value, what was the rate of return?
The relevant formula that will help answer these questions is:
F = P(1+i)**n  [p(1+i)((1+i)**n  1)/i]
In this formula, "F" is the future value of your investment (i.e., the
value after "n" months or "n" weeks or "n" yearswhatever the period
over which the investments are made), "P" is the present value of your
investment (i.e., the amount of money you have already invested), "p" is
the payment each period, "n" is the number of periods you are interested
in, and "i" is the interest rate per period. Note that the symbol '**'
is used to denote exponentiation (2 ** 3 = 8).
Very important! The values "P" and "p" should be negative . This
formula and the ones below are devised to accord with the standard
practice of representing cash paid out as negative and cash received (as
in the case of a loan) as positive. This may not be very intuitive, but
it is a convention that seems to be employed by most financial programs
and spreadsheet functions.
The formula used to compute loan payments is very similar, but as is
appropriate for a loan, it assumes that all payments "p" are made at the
end of each period:
F = P(1+i)**n  [p((1+i)**n  1)/i]
Note that this formula can also be used for investments if you need to
assume that they are made at the end of each period. With respect to
loans, the formula isn't very useful in this form, but by setting "F" to
zero, the future value (one hopes) of the loan, it can be manipulated to
yield some more useful information.
To find what size payments are needed to payoff a loan of the amount
"P" in "n" periods, the formula becomes this:
Pi(1+i)**n
p = 
(1+i)**n  1
If you want to find the number of periods that will be required to
payoff a loan use this formula:
log(p)  log(Pi  p)
n = 
log(1+i)
Keep in mind that the "i" in all these formula is the interest rate per
period . If you have been given an annual rate to work with, you can
find the monthly rate by adding 1 to annual rate, taking the 12th root
of that number, and then subtracting 1. The formula is:
i = ( r + 1 ) ** 1/12  1
where "r" is the rate.
Conversely, if you are working with a monthly rateor any periodic
rateyou may need to compound it to obtain a number you can compare
applestoapples with other rates. For example, a 1 year CD paying 12%
in simple interest is not as good an investment as an investment paying
1% compounded per month. If you put $1000 into each, you'll have $1120
in the CD at the end of the year but $1000*(1.01)**12 = $1126.82 in the
other investment due to compounding. In this way, interest rates of any
kind can be converted to a "simple 1year CD equivalent" for the
purposes of comparison. (See the article "Computing Compound Return"
for more information.)
You cannot manipulate these formulas to get a formula for "i," but that
rate can be found using any financial calculator, spreadsheet, or
program capable of calculating Internal Rate of Return or IRR.
Technically, IRR is a discount rate: the rate at which the present value
of a series of investments is equal to the present value of the returns
on those investments. As such, it can be found not only for equal,
periodic investments such as those considered here but for any series of
investments and returns. For example, if you have made a number of
irregular purchases and sales of a particular stock, the IRR on your
transactions will give you a picture of your overall rate of return.
For the matter at hand, however, the important thing to remember is that
since IRR involves calculations of present value (and therefore the
timevalue of money), the sequence of investments and returns is
significant.
Here's an example. Let's say you buy some shares of Wild Thing
Conservative Growth Fund, then buy some more shares, sell some, have
some dividends reinvested, even take a cash distribution. Here's how to
compute the IRR.
You first have to define the sign of the cash flows. Pick positive for
flows into the portfolio, and negative for flows out of the portfolio
(you could pick the opposite convention, but in this article we'll use
positive for flows in, and negative for flows out).
Remember that the only thing that counts are flows between your wallet
and the portfolio. For example, dividends do NOT result in cash flow
unless they are withdrawn from the portfolio. If they remain in the
portfolio, be they reinvested or allowed to sit there as free cash, they
do NOT represent a flow.
There are also two special flows to define. The first flow is positive
and is the value of the portfolio at the start of the period over which
IRR is being computed. The last flow is negative and is the value of
the portfolio at the end of the period over which IRR is being computed.
The IRR that you compute is the rate of return per whatever time unit
you are using. If you use years, you get an annualized rate. If you
use (say) months, you get a monthly rate which you'll then have to
annualize in the usual way, and so forth.
On to actually calculating it...
We first have the net present value or NPV:
N
NPV(C, t, d) = Sum C[i]/(1+d)^t[i]
i=0
where:
C[i] is the ith cash flow (C[0] is the first, C[N] is the
last).
d is the assumed discount rate.
t[i] is the time between the first cash flow and the ith.
Obviously, t[0]=0 and t[N]=the length of time under
consideration. Pick whatever units of time you like, but
remember that IRR will end up being rate of return per chosen
time unit.
Given that definition, IRR is defined by the equation: NPV(C, t, IRR) =
0.
In other words, the IRR is the discount rate which sets the NPV of the
given cash flows made at the given times to zero.
In general there is no closedform solution for IRR. One must find it
iteratively. In other words, pick a value for IRR. Plug it into the
NPV calculation. See how close to zero the NPV is. Based on that, pick
a different IRR value and repeat until the NPV is as close to zero as
you care.
Note that in the case of a single initial investment and no further
investments made, the calculation collapses into:
(Initial Value)  (Final Value)/(1+IRR)^T = 0 or
(Initial Value)*(1+IRR)^T  (Final Value) = 0
Initial*(1+IRR)^T = Final
(1+IRR)^T = Final/Initial
And finally the quite familiar:
IRR = (Final/Inital)^(1/T)  1
A program named 'irr' that calculates IRR is available. See the article
Software  Archive of InvestmentRelated Programs in this FAQ for more
information.
Check http://investfaq.com/ for updates
Compilation Copyright (c) 2002 by Christopher Lott.