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Investing in Stocks
and Bonds
Chapter 12
How Will This Affect Me?
Once you’ve figured out how much you need to invest to meet important financial goals, it’s
time to decide which specific investments to buy. This chapter describes the basic characteristics
of stocks and bonds, explains their potential returns and risks, and provides a framework for
choosing among stocks and bonds to meet your financial objectives. Care is taken to explore how
stock and bond prices behave and how to evaluate their performance over time. After reading this
chapter you should be able to choose the most appropriate stocks and bonds for your portfolio in
light of your goals and constraints.
You will need to spend some time with this chapter. If you assign and go over several of the
homework problems, it will take 4 or 5 50-minutes classes. As I said at the beginning of Chapter
11, this is important material and is worth the time.
The material in this chapter is best learned in a hands-on exercise. As suggested in Chapter 11,
some investing game would help make the concepts here real. Perhaps the game could be played
over a longer period as part of an investment club. Perhaps prizes could be awarded for the best
performance. Maybe even a scholarship for nest semester or graduate study could be offered.
Alumni could be involved by meeting with the students occasionally to comment on what they
are doing.
In not the above, assign the Financial Planning Exercises which ask the student to make
investment decisions.
Learning Goals
LG1 Describe the various types of risks to which investors are exposed, as well as the sources of
return.
The goal here is learning terminology and understanding the trade-offs. Power points will be
sufficient.
LG2 Know how to search for an acceptable investment on the basis of risk, total return, and
yield.
Learning the discipline of computing the various statistics and writing down the alternatives will
help the student in the long run. Insisting on written comparisons in the homework will go a
long way in achieve this.
LG3 Discuss the merits of investing in common stock and be able to distinguish among the
different types of stocks.
As you go through the types of stocks, giving examples of companies that match the stock type
will help make real to students.
LG4 Become familiar with the various measures of performance and how to use them in placing
a value on stocks.
The financial planning exercises give opportunities for the student to compute these measures as
well as read reports that give these measures for the company being reported. Use them.
LG5 Describe the basic issue characteristics of bonds, as well as how these securities are used as
investment vehicles.
If the students have had principle of accounting, they should be familiar with terms concerning
investment in bonds. The focus here in on terminology.
LG6 Distinguish between the different types of bonds, gain an understanding of how bond prices
behave, and know how to compute different measures of yield.
The financial planning exercises give opportunities for the student to compute the yields and I
suggest that you assign them.
Financial Facts or Fantasies?
These may be used as “teasers” to get the students on the right page with you. Also, they may be
used as quizzes after you covered the material or as “pre-test questions” to get their attention.
• You would have to save $2,500 a year in order to end up with a $25,000
nest egg in ten years.
Fantasy: Each year you will earn interest on the previous amounts saved.
Therefor if you invest $2,500 per year, in ten years you will have more than
$25,000. At a 5% rate, you will have $31,445.
• A good investment is one that offer a positive rate of return.
Fantasy: A good investment is one that offer an expected return that
equals or exceeds the investor’s required rate of return, which is defined
relative to the risk of the investment. Thus, what might be a good return in
one case may be totally inadequate in another.
• Income stocks have relatively high dividend yields and, as such, appeal to
individuals who seek a high level of current income.
Fact: Income shares are have a long and sustained record of regularly
paying a much higher than average level of dividends. Because of this, they
are highly sought after by investors seeking a safe and steady source of
current income.
• Putting your money into stocks that o%er dividend reinvestment plans is a
great way of building up your investment capital.
Fact: In a dividend reinvestment plan, you receive additional shares of stock,
rather than cash every time the company pays a dividend. It’s a great way to
reap the benefit of compounding and watch your money grow over time.
• When interest rates go down, bond prices also go down because such
securities become less valuable.
Fantasy: Bond prices and interest rates move in the opposite direction. As a
result, when interest rates go down, bond prices go up.
• Convertible bonds are so named because they can be exchanged for a set
number of shares of common stock.
Fact: Convertible bonds carry the provision that they may, within a
stipulated time period, be converted into a certain number of shares of the
issuing company’s common stock.
Financial Facts or Fantasies?
These may be used as a quiz or as a pre-test to get the students interested.
1. True False You would have to save $2,500 a year in order to end up
with a $25,000 nest egg in ten years.
2. True False A good investment is one that offer a positive rate of
return.
3. True False Income stocks have relatively high dividend yields and, as
such, appeal to individuals who seek a high level of current
income.
4. True False Putting your money into stocks that o%er dividend
reinvestment plans is a great way of building up your
investment capital.
5. True False When interest rates go down, bond prices also go down
because such securities become less valuable.
6. True False Convertible bonds are so named because they can be
exchanged for a set number of shares of common stock.
Answers:
YOU CAN DO IT NOW
The “You Can Do It Now” cases may be assigned to the students as short cases or problems.
They will help make the topic more real or relevant to the students. In most cases, it will only
take about ten minutes to do, that is, until the student starts looking around at the web site. But
they will learn by doing so.
YOU CAN DO IT NOW
What’s the Market P/E Ratio Telling You?
Nobel Prize-winning Professor Robert Shiller came up with the Shiller P/E
ratio, which is based on average in:ation-adjusted price multiples over ten
year intervals. Many use it to get a sense of whether the overall stock market
is properly valued. You can check out the current Shiller P/E ratio vs.
historical averages for the U.S. and several other major stock markets at the
interesting Research A>liates site:
https://www.researcha/liates.com/AssetAllocation/Pages/Equities.a
spx. You can do it now.
YOU CAN DO IT NOW
What’s the Market P/E Ratio Telling You?
Nobel Prize-winning Professor Robert Shiller came up with the Shiller P/E
ratio, which is based on average in:ation-adjusted price multiples over ten
year intervals. Many use it to get a sense of whether the overall stock market
is properly valued. You can check out the current Shiller P/E ratio vs.
historical averages for the U.S. and several other major stock markets at the
interesting Research A>liates site:
https://www.researcha/liates.com/AssetAllocation/Pages/Equities.a
spx. You can do it now.
YOU CAN DO IT NOW
How Do Stock and Bond Market Returns Compare This Year?
If you want a broad sense of how stock and bond returns compare so far this
year, take a look at the returns on two broad-based exchange traded funds
(ETFs, which we discuss in detail in chapter 13). Vanguard’s Total Stock
Market ETF (ticker VTI) seeks to track the overall performance of U.S. stocks
traded on the New York Stock Exchange and NASDAQ. And Vanguard’s Total
Bond Market ETF (ticker BND) seeks to track investment grade U.S. bonds.
Take a look at the YTD returns, which were, for example, 2.29 percent for VTI
and 1.29 percent for BND on May 21, 2015. Just go to
http://4nance.yahoo.com/ and type VTI and then BND into the Quote
Lookup box. You can do it now.
How Do Stock and Bond Market Returns Compare This Year?
If you want a broad sense of how stock and bond returns compare so far this
year, take a look at the returns on two broad-based exchange traded funds
(ETFs, which we discuss in detail in chapter 13). Vanguard’s Total Stock
Market ETF (ticker VTI) seeks to track the overall performance of U.S. stocks
traded on the New York Stock Exchange and NASDAQ. And Vanguard’s Total
Bond Market ETF (ticker BND) seeks to track investment grade U.S. bonds.
Take a look at the YTD returns, which were, for example, 2.29 percent for VTI
and 1.29 percent for BND on May 21, 2015. Just go to
http://4nance.yahoo.com/ and type VTI and then BND into the Quote
Lookup box. You can do it now.
Financial Impact of Personal Choices
Read and think about the choices being made. Do you agree or not? Ask the students to discuss
the choices being made.
Landon and Kirsten Like High Flying Stocks
Landon and Kirsten Malloy are both 33 years old and invest 15 percent of
their after-tax annual income in stocks. They hate missing out on great
returns when the stock of a company doing great things starts going through
the roof. For example, Landon and Kirsten feel they should have invested in
Electronic Arts in 2014 when it earned around a 60 percent return! So any
time a company they know well earns more than 20 percent in a year, they
try to invest in it. And because they believe in the stocks they buy, the
Malloys always hold their stocks until they at least break even. What do you
make of the Malloys’ approach to stock investing?
The Malloys decision to invest 15 percent of their after-tax income is great.
However, Landon and Kirsten shouldn’t invest just in stocks and should adopt
an asset allocation strategy that provides diversified exposure to bonds, real
estate, and more. Their current exclusive focus on stocks is likely too risky.
Further, their rule to buy well-known stocks that earn more than a 20 percent
return in a year likely leaves them insu>ciently diversified. And their 20
percent return rule also focuses too much on past returns and not enough on
a careful forecast of future returns. The Malloys could end up with overvalued
stocks with their best performance behind them. Finally, their rule to not sell
until they at least break even suggests the behavioral bias of unduly
“anchoring” on purchase prices. It could be that a company has changed for
the worse and it’s simply time to sell, even if it implies a loss. Investing 15
percent of their income is great, but the Malloys could do even better.
Test Yourself
12-1 Describe the various types of risk to which investors are exposed.
1. Business risk is the variability surrounding the firm’s cash flows and subsequent ability to
2. Financial risk concerns the amount of debt used to finance a firm, as well as the possibility
3. Market risk results from the behavior of investors in the securities markets that can lead to
5. Fixed-income securities—which include notes, bonds, and preferred stocks—offer investors
a fixed periodic cash flow and, as such, are most affected by interest rate risk. As interest rates
6. The risk of not being able to liquidate (i.e., sell) an investment conveniently and at a
7. Event risk occurs when something substantial happens to a company and that event, in itself,
12-2 What is meant by the risk-return trade-off? What is the risk-free rate of return?
The amount of risk associated with a given investment vehicle is directly related to its expected
Note that it’s possible to receive a positive return for zero risk, such as at point A. This is referred
12-3 Briefly describe the two basic sources of return to investors.
Any investment vehicle—whether it’s a share of stock, a bond, a piece of real estate, or a mutual
Current income is generally received with some degree of regularity over the course of the year.
The other type of return available from investments is capital appreciation (or growth), which is
reflected as an increase in the market value of an investment vehicle. Capital gains occur when
12-4 What is interest on interest, and why is it such an important element of return?
Note that because the bond was originally bought at par ($1,000), you start off with a 4 percent
investment. Where you end up depends, in large part, on what you do with the interest earnings
12-5 What is the desired rate of return, and how would it be used to make an investment
decision?
The value of any investment depends on the amount of return that it’s expected to provide
relative to the amount of perceived risk involved. The minimum rate of return that you believe
12-6 From a tax perspective, would it make any difference to an investor whether the
return on a stock took the form of dividends or capital gains? Explain.
Historically yes it mattered. However, for tax years beginning after 2012, qualified dividends
[basically those from domestic corporations and qualified foreign corporations] are taxed at 20%
12-7 What’s the difference between a cash dividend and a stock dividend? Which would
you rather receive?
Cash dividends are paid to the stockholder in cash and are taxable at the capital gains rate. Stock
dividends paid to the shareholder in stock and are non-taxable. Stock dividends have no current
Cash is always acceptable and most likely preferred. Receiving cash allows the shareholder to
12-8 Define and briefly discuss each of these common stock measures: (a) book value, (b)
ROE, (c) EPS, (d) P/E ratio, and (e) beta.
The amount of stockholders’ equity [assets minus liabilities minus preferred stock] in a firm is
Return on equity (ROE) reflects the firm’s overall profitability from the equity holders’
Earnings per share (EPS) translates total corporate profits into profits on a per share basis and
provides a convenient measure of the amount of earnings available to stockholders. It is
computed as:
When the prevailing market price of a share of common stock is divided by the annual EPS, the
A stock’s beta is an indication of its price volatility; it shows how responsive the stock is to
changes in the overall stock market. Low-beta stocks—those with betas of less than 1.0—have
low price volatility (their prices are relatively stable), whereas high-beta stocks—those with
12-9 Briefly discuss some of the different types of common stock. Which types would be
most appealing to you, and why?
1. blue-chip stock A stock generally issued by companies expected to provide an uninterrupted
2. growth stock A stock whose earnings and market price have increased over time at a rate that
3. Tech stocks represent the technology sector of the market and include all those companies
that produce or provide technology-based products and services such as computers,
4. Stocks whose appeal is based primarily on the dividends they pay are known as income
5. Investors in speculative stocks gamble that some new information, discovery, or production
6. Stocks whose price movements tend to follow the business cycle are called cyclical stocks.
7. In the stock market, a stock’s size is based on its market value—or, more commonly, on
12-10 Summarize the evidence on the potential cost of being out of the stock market during
its best months.
A common myth: During volatile markets, it makes sense to sell your stocks and wait for
calmer conditions. While it sounds so reasonable, investors who remain in the market
outperform those who move in and out to manage their market exposure. When trading in and
12-11 What are DRPs, and how do they fit into a stock investment program?
The investment philosophy at work with a dividend reinvestment plan (DRP) is this: if the
company is good enough to invest in, then it’s good enough to reinvest in. In a DRP, shareholders
12-12 Go to the asset allocation tool provided at the following internet site:
http://www.ipers.org/calcs/AssetAllocator.html. Enter assumptions that fit your current
and anticipated situation and produce an asset allocation recommendation. Then add 20
years to your age and redo the calculations. Finally, redo the calculations assuming
minimal risk tolerance. Explain the results of changing these key assumptions.
I inserted the age of 20, current assets $100,000, savings per year $5,000, tax rate 28%, 0%
I changed the age to 40, kept all other the same. The suggested allocation was 71% stocks, 12%
The suggested allocation became more conservative with higher bonds and cash. However, the
12-13 What’s the difference between a secured bond and an unsecured bond?
Secured bonds have specific assets as collateral for the bond. In effect, it is like a mortgage.
Unsecured bonds do not have any specific assets pledged to support the bond and as such are like
12-14 Are junk bonds and zero coupon bonds the same? Explain. What are the basic tax
features of a tax-exempt municipal bond?
Zero coupon bonds, as the name implies, are bonds issued without coupons. To compensate for
their lack of coupons, these bonds are sold at a deep discount from their par values and then
Junk bonds are rated by the rating agencies in the lowest category. These ratings indicate that,
although the principal and interest payments on the bonds are still being met, the risk of default
Municipal bonds are issued by a state or a political division of a state. The interest on the bonds
are exempt from federal income tax, but any gain from holding the bonds will be taxable. Thus,
12-15 What is a convertible bond, and why do investors buy convertible securities?
The convertible bond, found only in the corporate market, is a type of hybrid security because
they possess the features of both corporate bonds and common stocks. That is, though they’re
initially issued as debentures (unsecured debt), they carry a provision that enables them to be
12-16 Describe the conversion privilege on a convertible security. Explain how the market
price of the underlying common stock affects the market price of a convertible bond.
The key element of any convertible issue is its conversion privilege, which describes the
conditions and specific nature of the conversion feature. First, it states exactly when the bond can
be converted. Sometimes there’ll be an initial waiting period of six months to perhaps two years
Convertibles seldom trade precisely at their conversion value; instead, they usually trade at
12-17 Explain the system of bond ratings used by Moody’s and Standard & Poor’s. Why
would it make sense to ever buy junk bonds?
Bond ratings are like grades: A letter grade is assigned to a bond, which designates its investment
quality. Ratings are widely used and are an important part of the municipal and corporate bond
Junk bonds are more risky than AAA bonds. In order to sell the bonds they may have a higher
12-18 Explain the difference between dirty (full) and clean bond prices? What is the
significance of the difference in the prices for a bond buyer?
In market jargon, how accrued interest is treated in bond pricing is the basis for the distinction
12-19 What effects do market interest rates have on the price behavior of outstanding
bonds?
If the market price goes up, the bond value goes down. The interest that will be paid is set by the
