Investing

Investing in Stock/Share Markets

  1. Market
  2. Securities Trading System
  3. Clearing and Settlements
  4. Regulation
Efficiency depends on the speed of information flows.
Brokers are members of the exchange who have the right to trade and put in orders. 
 
Debt can also be issued on stock markets e.g. bonds, preference shares, convertible notes. 

Investing vs Trading

Investing:  Purchasing and holding financial assets for the long-term, to benefit from growth. 

Trading: Frequent buying and selling to make profits.  Trading is also good for investors as it increases overall liquidity in market and increases likelihood you will find a counterparty.

Types of Markets

Dealer – OTC, market-maker:  Dealer acts as counterparty for buyer and seller and quotes bid-ask prices.
Common in bond and currency markets. 
Most liquid type of market

Broker:  finds counterparty for buyers and sellers
Common for IPOs

Exchange-traded: Automated broking, trades executed based on order books.

Investment Strategies

Approaches

Value

Investing in established companies that have been profitable over a period of time and offer dividends
Often mature companies like the blue-chip
Risk-averse approach to investing and better for shorter-term needs

Growth

Investing in companies that show potential for future growth
Often innovative and early-stage companies like tech startups
Riskier approach and requires longer-term time horizon

Direct Investment

Buying and selling stocks

Purchase of individual stocks

  

Indirect Investment

Active

Fund manager actively picks stocks (e.g. REITs)

Passive

Fund which tracks and index (e.g. ETFs)

 

Fundamental and Technical Analysis

 

Fundamental Analysis – what to buy

Finding a stock’s intrinsic value

Qualitative

  • Market conditions
  • Trends, disruption
  • Management team

Quantitative

  • Financial statement ratios
  • Assets, liabilities
  • Revenue, earnings, cashflow

Technical Analysis – when to buy

Approach

Use of asset-specific price and trading activity such as charts

Uses

Used by day traders (short-term)

 

Fundamental Investment Analysis

Approaches

Time-series Analysis

Comparison of a firm with itself over a period of time

Cross-sectional Analysis

Looking at different companies within an industry at different points in time

Benchmark

Comparison against industry norms

Techniques

Comparative Analysis

Comparison of financial statements of a company to identify trends

Common Size Analysis

Analysis of items within financial statements

-Income Statement items are reported as % of revenue

-Balance Sheet items are reported as % of assets

Ratio Analysis

Ratio of two or more items on financial statements

Financial Analysis Ratios

Managed Products

Exchange-traded Funds (ETFs)

Diversified portfolio of shares

Real Estate Investment Trusts (REITs)

Diversified interest in real estate

Infrastructure Funds

Diversified interest in infrastructure projects

Derivatives and CFDs

Derive value from underlying asset, some highly leveraged

Risk and Return

Risk and return are major considerations in the investment decision. 
Return is measured by expected value – the outcomes weighted by their probabilities, and the risk is measured by standard deviation – the distribution of returns from their mean. 

Return

Return = Income (dividend) + capital gains
Rate of Return = Return / Purchase price

Expected Return

However, we don’t know future payoffs, so look at Expected Return, based on probability of payoffs

Expected Value = Outcome x Probability

EV = P(A(%)) * Outcome A  +  P(B)[100%-P(A)]

Risk

Variance – Distance from mean squared
Var = x – [mean of x]

Standard Deviation – Squareroot of Variance, or avg distance from mean
SD = √ Var

Portfolio diversification

Good performing assets offset badly-performing ones.
Generally, high risk leads to high returns, but not for risk due to non-diversification.
Diversify through:

  • asset class – fixed income, shares, alternate
  • size – small, mid or large cap
  • industry
  • defensive/growth assets

Systematic risk

Relating to whole market or economy – cannot be reduced through portfolio diversification (“beta”). 

Unsystematic risk / 
Diversifiable risk

Relating to specific share/company – asset-specific risks, which can be reduced through portfolio diversification, up to a point (also known as “alpha”). 

Asymmetric bet: upside is very different to downside

Standard and Alternative Investments

Standard Investments

Alternative Investments

  • Cash
  • Bonds / Fixed interest
  • Shares
  • Property (real estate)
  • Derivatives, hedge funds, futures
  • Private equity, venture capital
  • Commodities, real estate, forex

Derivatives

Definition – Financial instrument whose value is derived from an underlying asset

Purpose   – to manage risks of price fluctuations

Example  – Farmer locks in price of wheat sale now to protect against risk of currency downturn.  Underlying asset (wheat) is sold and physically delivered separately

Uses        – Hedging and speculation

Exchange-traded

Standardised and traded on an exchange

Over-the-counter

Non-standardised and negotiated and traded directly between buyer and seller

Types of Derivatives

Future

Agreement to buy physical asset (commodity, energy or metals) at future date for specified price.  Exchange-traded.

Forward – OTC (direct between parties)

Option

Right to buy or sell commodity at future date for specified price

Buy – call (spot price > strike price) i.e. buy at strike price

Sell – put (spot price < strike price)

In-the-money: Exercised within the above rules

Out-of-the-money:  The rules are not met, so option is useless

Covered: satisfaction of option is guaranteed

Naked: no guarantee it will be completed

Swap

Agreement to exchange cash flows from underlying assets

CFD

Contract-for-difference:  Exchange of the difference in value of underlying asset between contract open and close dates

Hedging using derivatives involves entering into two contracts:

  • Contract to buy or sell the underlying asset
  • Contract for futures
Movements in the physical market are offset by movements in the futures market as the position in the asset contract and futures contract are opposite.  E.g. If a farmer sells a futures contract (short). 
If the price of the wheat increases, the value of the futures contract will fall as the farmer buys back futures at a higher price to close out the position.  The gain in the price of wheat is offset by the loss in the futures contract.

Derivatives Trading

Margin Requirements

Trading platforms require a percentage of the sale price to be posted in advance to make sure buyers and sellers can wear losses

Long Position

Investor owns the asset – expecting its value to rise (bull market)

Short Position

Investor sells an asset which it has borrowed – buy later at a lower expected price (bear market)

Call

Option to buy

Put

Option to sell

Open Position

A trade that has not been closed

Closing out a contract

Reverse the contract by entering into opposite position – e.g. sell long position or buy asset in short position

Objectives/Strategies

Hedge – reduce risk in price fluctuations

Speculate/Trade – aim to make profit from price fluctuations (instead of capital gains e.g. shares)

Arbitrage – take advantage of price differentials

Indicies

Efficient Markets Hypothesis​

Stock/share prices reflect all available information.  They trade at their fair value – are not under- or over-valued.  Therefore, there can be no arbitrage and investors cannot outperform the market in the long-term.

Strong Form

Public and private (insider) info is reflected in stock prices

Semi-strong Form

Historical and current public info is reflected in prices (current/new info is quickly assimilated)

Weak Form

Only historical public info is reflected in prices

Implementation

Bid-Ask Prices

Bid Price
(Buyer)

Maximum an investor is willing to pay (below market price)

Ask Price
(Seller)

Minimum a seller is willing to accept

(above market price)

Spread

Difference between bid and ask prices

Types of Orders

Market Order

Order to transact immediately, at or around market price. 
Execution is immediate.

Limit Order

Order above or below a specific price.  Once the price is reached, it becomes a market order.
Execution uncertainty exists, unless there is no spread. 

  • Buy limit: order to buy below a specific price
  • Sell limit: order to sell above a specific price
  • Buy stop-loss: order to stop buying above a specific price
  • Sell stop-loss: order to stop selling below a specific price

Order Book

Order Book

Spread

Ask – Bid

Price Impact of Order

Fulfilment of orders changes the best ask/bid prices

Order Aggression

Closer to best price

Partial Fulfilment

Order may be partially filled if not all shares can be matched

Dollar cost averaging:  spreading investment out rather than investing as a lump sum, to reduce risk of investing at the wrong time.
However, it doesn’t work well if the market price is rising – the average cost will increase.
It can also lead to a lot of brokerage fees being incurred. 

Dividends

Frequency

Usually half-yearly (interim dividend) and yearly (final dividend)

Ex dividend Date

4 days prior to Record Date – only shares purchased before this date are eligible to receive dividend, otherwise later purchase share “cum dividend”

Record Date

Date the company closes share register to assess eligibility for dividend (i.e. registration paperwork must be finalised)

Price Implications

Usually share price increases prior to ex dividend date, then reduces by amount of dividend

Short-selling

Long

Buy shares and place stop-loss order

Short

Sell shares and place stop-loss or market order
Prices are expected to decrease, so buy back at lower price.
If the price increase, results in losses

Trigger price

Price at which stop-loss or market order is triggered, execution price may be different

Liquidity

Immediacy

 

Width

 

Depth

 Number of shares that buyers and sellers are willing to trade at each price.

Resiliency

 

Transaction Costs

Explicit

Brokerage fees, taxes

Implicit

Spread, opportunity cost

  

Monitoring

Benchmarking

Use indexes to benchmark your investments (compare performance over the same period)

Rebalancing

Make changes if the asset allocation has changed over time
   
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