A Comprehensive Study of the Major Asset Classes - Term Paper Example

?Donna Purcell Order 606453 29 November A Comprehensive Study of the Major Asset es Including Stocks, Bonds, Mutual Funds, Options and Commodities Introduction What is an Asset Class? “It is a group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations” (Investorpedia, 2011). These classes include stocks, bonds, and cash equivalents, commodities, real estate, and other types can be included. Some investment professionals differ in terms of what is an actual asset class. Whatever the class is, each one is expected to perform in its own risk and return environment within the changing market. Before anyone even thinks about buying any stock thoughts need to include an investment strategy that fits your life, your personality and your risk absorption. Up front, what can you afford to lose? There are differing methods of trading stocks or any asset in the market. While some might consider it a game, when your money is on the line, it’s not a game. Before you begin its best to paper trade (trading on paper without actually investing any money or a mock scenario) for a while until you are consistently making money through whatever strategy you choose. When your actual money is on the line, you will be dealing with your own emotions of fear and greed. The following information delves into more detail of the procedure of buying any financial market asset, different types of stocks, equities and mutual funds. It also includes some of the advantages and disadvantages of the differing types. How to Proceed Trading can be done through a bank, a broker or online trading. Online trading has become very popular because of its convenience. Any investment has to be backed by an account that contains monetary funds. It depends on the bank or brokerage firm as to what the minimum deposit will be for opening a new account. The amount usually ranges from $500 to $2000. However, if you prefer to use online trading as an intraday trader, you would need a minimum of $25,000. An intraday trader buys and sells stocks repeatedly during the day. You will need to fill out forms with the brokerage firm and make a deposit into an account opened with them. Most brokerage firms furnish their own software for trading online; however, there are independent companies that provide online trading software. When you buy you can choose a market or limit order. The market order is purchased at whatever is the current price. The limit order is placed at a price you choose. It’s especially helpful to shop around for brokers and banks because they all have their own set of rules, and fees. Purchasing Stocks Exactly what is a stock? When you buy stock in any company, you actually own part of that company. If the company does well, so will your stock. If the company does poorly, so will your stock. A stock is not diversified, so this can be seen as a disadvantage. Placing money into one stock can limit your options. You can reduce your risk somewhat by investing in larger more solid companies. Stocks can be purchased anytime through your broker, bank, or online. Online is the most desirable way to purchase stocks because it is convenient, quick, and very accessible. One very favorable advantage to stocks is they are very liquid; meaning you can convert them to cash very easily by selling them anytime. The average person is normally not very good at picking excellent performing stocks. All stocks have ups and downs and it usually takes a professional or an experienced trader to recognize the fluctuations in certain stocks and sectors. The easiest way is to pick stocks that you like or products that you use and would like to own. A good starting point would be to pick from 10 to 15 on average. Examples could include whatever you like in the way of foods, clothing, etc. such as Gap or Abercrombie. Just because it’s a popular brand does not mean the stock will do well. A deeper probe into the history of the stock, the company, and the fluctuations will be needed. You will need to know the trends, their products, revenues, profits, growth, and earnings per share. It is also smart to watch their insider trading; are executives within the company buying or selling their stock? Another key factor is Management. Is management stable, is there a constant turnover, is it strong in leadership? All of this information can be obtained online at most any of the stock websites. Taking a close look at the companies’ financial statements in their annual reports is a smart starting place. Types of Stocks and Equities Purchasing common stock is the most popular. When rumors are circulating about buying stock it usually means common stock. Preferred stock is different in some ways. First of all they offer a dividend, which is fixed and shown as a percent of the stock price. Also, the dividends can be cumulative, which means if the dividends are not paid they will accumulate until the next year. Stockholders of preferred stock have say in liquidation procedures. Companies are not legally bound to pay dividends. There are also convertible preferred stocks, which can be changed to common stock at a suggested price. Preferred stock is an offering of fixed income with a small capital appreciation. There are also differing classes of stocks within the common and preferred. The different classes are created sometimes to lessen the voting rights of another class but still allow access to capital. An example would be Class A, owned by management, and has more voting power per share than a Class B. This normally keeps controlling shares within the company. An IPO “initial public offering” is another type of stock. This is companies’ first sale of stock to the public. The main reason a company offers stock to the public is to raise capital for operation of the business. Issuing an IPO is called underwriting and is a very extensive process. Blue chip stocks are well established, well know, and financially stable companies. These stocks are normally less volatile and hold a history of paying dividends in good and bad times. Growth stocks are normally companies with higher earnings and market share within its industry and the economy. These stocks usually reinvest their profits on expansion and building the business. They very rarely pay dividends as their earnings are used to finance expansion. These stocks are very desirable as they are expected to grow with the company. Penny stocks are very low priced stocks, normally below $5. They are considered very high-risk and traded over the counter (OTC). Value stocks are considered undervalued by investors. They are companies that normally have had money difficulties, not popular at the present, or their growth potential was not recognized. These stocks are recognized by their book/market and price/earnings ratios. Defensive stocks provide needed services like gas, electric, and food. These are normally very stable stocks during recessions or any financial slowdown. Income stocks pay high dividends coinciding with their market price. These stocks appeal to anyone looking for current income. These can include public utilities and blue chips. Cyclical stocks roll with the business cycle. When the business atmosphere is good or bad, the company either prospers or doesn’t along with its stock price and earnings. Some examples are airlines, autos, steel, paper, and furniture. Seasonal stocks are self-explanatory; they move as the seasons change. An example would be companies that depend on Christmas sales or the start of the school year. International stocks deal with other markets. The US equity market consists of around one third of the world markets. International stocks are a consideration when diversifying what you buy. However, they come with additional risk such as volatility, lack of liquidity, and lack of research. There is, also, the constant threat of social, political, and monetary risks with any international investment. Bonds Bonds are like CDs, you buy them and let them sit in the bank for 1, 2 or 5 years, and they draw interest at the current rate. The longer you leave the bond, the higher the interest rate. Bonds are very stable; government bonds are especially stable. However, you are at a disadvantage as a bond will not do as well as a stock. With bonds your money is not accessible until the end date of the bond. These are usually attractive to older people and rich people who need stability in their monthly income. If you have $10 million you want to preserve, at 2 or 3 percent with a guaranteed bond the return will be $300,000. Bonds are not popular with young people who are looking for growth investments. Mutual Funds Mutual funds are formed from money from different investors poured into stocks, bonds and other assets. These would be 401Ks, IRAs, or taxable investment accounts. Investors simply buy shares of a mutual fund and the fund manager buys large amounts (example, stocks). The investor owns a small portion of the asset within the fund. Mutual funds are very diversified which is a great advantage to a small investor. Being professionally managed simplifies the process for its members; and funds can become liquid within a few days time. The purpose of the stock fund is for long term appreciation. There are costs involved in the form of management fees that include sales charges, administrative fees, and marketing expenses. You could have a tax bill if the fund drew a profit on the sale of a stock but the portfolio falls in the negative. Sometimes fund managers are forced to purchase assets at a higher price due to so much money to invest. This can hurt the investor in the long run. There is a constant inflow and outflow of money, which can reduce the managers’ ability to always buy or sell at the best times. These stocks are normally large cap stocks. Large cap funds invest in large “blue chip” companies within industrials, utilities, technology and financials with larger market capital. These are seen less risky than smaller markets. Large caps are generally greater than $10 billion in market capital. Mid cap funds invest in companies smaller than large cap companies. Mid caps funds have a market cap of between $1.5 billion and $10 billion. These are riskier than large caps but are expected to give a higher return. Small caps funds invest in new or emerging companies who are expected to grow and profit. They are considered very risky and volatile. Small cap stocks have a market cap of less than $1.5 billion. An example would be Ann Taylor Stores, who has a market cap of $1.2 billion. International funds invest in stocks traded on foreign exchanges. However, they are purchased in the US by US fund companies. These are prone to currency fluctuations, political instability and very non-liquid. Sector funds deal with industry sectors in technology, financials, health or energy. Since these are more specific to a certain sector, they are prone to be at greater risk than funds with varying diversification. Bond Funds Government bond funds invest in bonds issued by the US Department of Treasury and other federal agencies and are taxable. Municipal bond funds buy bonds issued by state and local governments to fund schools, streets, highways, hospitals, bridges, and airports. These can be insured and tax-free. Corporate bond funds are issued by corporations to fund their business ventures and they are taxable. Bond funds are not guaranteed and go up and down with market conditions and interest rates. These have a greater risk to principal than Certificates of Deposit as they can be worth more or less at maturity. Money Market Funds Money market funds are short-term securities like Treasury bills. Most offer higher rates of interest than a savings account. Some are tax-free; however, are not FDIC insured. They are created to be more stable than stock or bond funds. They provide stable dividend income, but the yield fluctuates daily. Balanced Funds Balanced funds invest in bonds, stocks and cash in differing amounts. They produce dividends, capital gains, and elevated share prices according to their allocation in the major asset classes. Asset Allocation Funds The manager of this fund will divide the assets among each category and distribute them according to portfolio strategy. Portfolio strategies are usually divided according to risk involved. Divisions are normally Aggressive Growth, Growth Strategy, Growth and Income Strategy, and Income Strategy. These can include other mutual funds as the market changes. The manager can increase or decrease exposure in a fund. Almost all mutual funds allow you to switch funds in the same class A, B, or C with no cost to the investor. Futures and Commodities Futures involves a producer and buyer who agree to trade in advance to offset the fluctuation in the price of a good or service. Example, a baked goods company might want to buy a certain amount of sugar at a set price. Other traders can buy into this trade to reduce the risk of product failure or a bad harvest. It has the advantage of leverage as the buyer does not have to possess cash for the trade. A disadvantage would be time as the speed of the trade is very slow. Online trading is much faster in this sector. There is no falling point due to time limit on commodities, and someone outside the initial trade can make money whether or not the price is rising or falling. The greatest advantage in futures and commodities is that the contracts are very high in liquidity. Options Options are simply the trade in option contracts over an exchange. Advantages include leverage, risk/reward ratios are lower, and you can use unique strategies to the investor’s advantage. These include volatility and time restraints. Options allow positions to be taken with very low capital requirements. One thousand can produce much more in options than in the stock market. Disadvantages would be lower liquidity, higher spreads, higher commissions, and time decay. However, options are harder to learn and present complications for beginners. It’s harder to obtain information on options pertaining to volatility, and options are not readily available for all stocks. Conclusion We have taken a close look at the asset classes from stocks to options. The information gives a detailed description of the procedures of buying a stock. This includes what a stock is, setting up an account, and trading. Further information shows the difference between common and preferred stock as well as other types. Mutual fund information goes into detailed depth concerning bonds, money market funds, balanced funds and asset allocation funds. A brief description includes futures, commodities and options along with their advantages and disadvantages. “Studies have shown that the key to successful investing is to spread your wealth among different asset classes” (Smart, 1996 – 2000). With any type of investment there are no guarantees. Changing market conditions can create up and down fluctuations in the value of a mutual fund. Stocks can go up and down in the same manner according to changing market conditions. When considering how and where to invest, do your due diligence and research. It’s important to compare differing costs of differing funds before investing. “Always look at the net returns when comparing fund and stock performances. Net returns is the bottom line; an investment’s true return after all costs are deducted” (The Financial Planning Center, 2011). References Advantages and Disadvantages of Futures Commodities Trading. “Golden Opportunity.” 26 February 2011. Web. 28 November 2011. http://futures-andcommodities-trading.com/. All About Stocks and Bonds. 17 August 2004. Web. 29 November 2011. http://iwillteachyoutoberich.com/. Asset Class. “Investopedia.” Web. 28 November 2011. http://investopedia.com/. Equities: Types of Stocks. “Equity Research – Stock Types/ Prudential.” Web. 29 November 2011. http://prudential.com/. Fund Advantages and Disadvantages. “The Financial Planning Center.” Web. 28 November 2011. http://open-ira.com/. How to Buy Stocks. “TradeStocksAmerica.com.” 2011. Web. 29 November 2011. http://tradestocksamerica.com/how-to-buy-stock/. Intro to IPOs. “Thinktrade.” Web. 29 November 2011. http://thinktrade.net/ipos/. Mutual Fund Categories. “The Financial Planning Center.” Web. 29 November 2011. http://open-ira.com/Education_Center/. Mutual Funds Explained. “Fisher Investments.” Web. 29 November 2011. http://investing-school.com/. Smart, Cathy. “Small-and Mid-Cap Stocks: Bigger isn’t Always Better.” 401Kafe.com 1996- 2000. Web. 28 November 2011. http://inforplease.com/finance/. The advantages and disadvantages of options. “Thinktrade.” Web. 29 November 2011. http://thinktrade.net/options-advantages-and-disadvantages/. Types of Stocks. “Thinktrade.” Web. 29 November 2011. http://thinktrade.net/types-of-stocks/. Read More