# C H A P T E R Investing in Stocks 421

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1 Investing in Stocks C H A P T E R 15 Walter Woodward owned 500 shares of a stock that he bought at \$40 per share. As the price rose steadily over the course of several months to over \$48, Walter decided to implement a sell strategy that would take the uncertainty out of the sales transaction. He called his broker and placed a limit order to sell his stock if and when it reached \$50 per share. A \$50 per share price would allow Walter to earn at least a 25 percent return on his investment and result in a \$5,000 gain before subtracting the commissions. As the stock neared the \$50 mark, Walter was pleased with his investment. Only a few more days, it seemed, and he would reap his 25 percent gain. Closer and closer the price came to \$50. First it reached \$49, then \$49.25, and finally \$49.50 per share. Unfortunately for Walter, that was to be the highest price for his stock. Over the next few days the price slipped to the mid-40s and then drifted lower still. Walter didn t sell because he was sure it was only a temporary setback. Soon it was back to his original purchase price of \$40 per share. Since Walter had not lost any money yet, he held his stock. Week after week the price of his stock shares drifted lower. Finally, when they reached \$30 per share, he called his broker and sold all of his shares. Walter ultimately suffered a \$5,000 loss on his investment. There is no way to determine in advance the opportune time to sell a stock. In Walter s case, a perfectly suitable investment decision was thwarted by the uncertainties of the market. Perhaps his expectations were too high. Perhaps he could have settled for a 20 percent gain. 421

11 ASSESSING PERFORMANCE OF STOCK INVESTMENTS 431 COMPARING RETURNS TO AN INDEX A convenient and effective method of measuring performance is to compare the return on your stock (or stock portfolio) to the return of a stock index representing similar types of stocks. Stock index returns are provided in most business periodicals and on numerous Web sites such as Yahoo! s site. EXAMPLE Stephanie Spratt invested in one stock about one year (or four quarters) ago. The returns on her stock are shown in column 2 in Exhibit Her return was lowest in the first quarter, but increased in the next three quarters. Stephanie wants to compare her stock s return to the market in general to get a true assessment of its performance. This comparison will indicate whether her specific selection generated a higher return than she could have earned by simply investing in a stock index. In Exhibit 15.1, the return on a market index over the same quarters is shown in column 3. Given the information in columns 2 and 3, Stephanie determines the excess return on her stock as: ER R p R i where ER is excess return, R p is the return of her stock portfolio, and R i is the return of the stock index. Exhibit 15.1 Stock Performance Evaluation Excess Return of Return on Return on a Stephanie s Stock Stephanie s Stock U.S. Stock Index (above the market) Quarter 1 1% 3% 4% Quarter 2 2% 3% 1% Quarter 3 5% 7% 2% Quarter 4 6% 9% 3% The excess return of the stock was negative in each of the four quarters. Stephanie is disappointed in the performance of the stock, and decides to sell it in the near future if its performance does not improve. PRICE QUOTATIONS FOR INDEXES USED TO MEASURE STOCK PERFORMANCE Quotations of levels for market and sector indexes are reported in financial newspapers. For example, the Wall Street Journal provides stock index quotations, as shown in Exhibit The Wall Street Journal shows the range of index levels during the previous day. It also provides the percentage change in each stock index over the previous day, the last 12 months, and since the start of the calendar year. Thus, it serves as a useful indicator of the general shortterm stock market performance.

12 432 I N V E S T I N G I N S T O C K S Exhibit 15.2 An Example of Stock Index Information Copyright 2003 Dow Jones & Company, Inc. All Rights Reserved. Consider the Standard & Poor s MidCap 400 index highlighted in Exhibit The index level reached a high of and a low of for the day. When the market closed for the day, the index level was , which was up.54 percent from the previous day. The index was down percent over the previous 12 months and down percent since the end of the previous year. Notice how easily you can compare this index with an index of smaller firms or an index of much larger firms to determine the relative performance of other firms. HOW STOCK INVESTMENT METHODS FIT WITHIN YOUR FINANCIAL PLAN The following are the key decisions about investing in stock that should be included within your financial plan: 1. Should you consider buying stock?

13 HOW STOCK INVESTMENT METHODS FIT WITHIN YOUR FINANCIAL PLAN Financial Planning Online: Stock Market Summary Go to: Click on: Markets This Web site provides: a summary of recent stock performance Financial Planning Online: Stock Index Quotations Go to: m1?u This Web site provides: recent quotations of indexes that can be used as benchmarks when assessing your investment portfolio s performance. Click on Charts to review historical movements in any specific index so that you can assess the general trend in the performance of this index.

20 440 I N V E S T I N G I N S T O C K S 14. On the New York Stock Exchange, help to make a market in one or more stocks by taking the position opposite of orders placed by clients. a. specialists b. floor traders c. position traders d. market-makers 15. execute in trades desired by other investors on the New York Stock Exchange. a. Margin traders b. Position traders c. Floor traders d. Market-makers

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