How the Stock Market Works Course Guidebook

TTopic Business Subtopic & Economics Economics How the Stock Market Works Course Guidebook Professor Ramon P. DeGennaro The Unniversityy of Tennessee, Knoxville PUBLISHED BY: THE GREAT COURSES Corporate Headquarters 4840 Westﬁelds Boulevard, Suite 500 Chantilly, Virginia 20151-2299 Phone: 1-800-832-2412 Fax: 703-378-3819 www.thegreatcourses.com Copyright © The Teaching Company, 2014 Printed in the United States of America This book is in copyright. All rights reserved. Without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording, or otherwise), without the prior written permission of The Teaching Company. Ramon P. DeGennaro, Ph.D. CBA Professor in Banking and Finance The University of Tennessee, Knoxville rofessor Ramon P. DeGennaro is the CBA Professor in Banking and Finance at The PUniversity of Tennessee, Knoxville. He also has served as a Visiting Scholar at the Federal Reserve Banks of Cleveland and Atlanta and for the American Institute for Economic Research. Professor DeGennaro holds a B.S. in Education from The Ohio State University, an M.Ed. from Ohio University, and a Ph.D. in Finance from The Ohio State University. 3URIHVVRU 'H*HQQDUR¶V FXUUHQW UHVHDUFK LQYROYHV LQYHVWPHQWV ¿QDQFLDO markets, and entrepreneurship. He has published more than 40 refereed DUWLFOHVRQLQYHVWPHQWV¿QDQFLDOPDUNHWYRODWLOLW\VPDOO¿UP¿QDQFHWKHWHUP VWUXFWXUHRILQWHUHVWUDWHV¿QDQFLDOLQVWLWXWLRQVDQGSUHGLFWLRQPDUNHWV+HDOVR has written research reports, book chapters, book reviews, and several Federal Reserve publications. Professor DeGennaro is an associate editor or member of the editorial boards of The Journal of Financial Research, The Financial Review, the International Journal of Business, and The Journal of Private Enterprise. In addition, he is a member of the Academic Board of Directors of the Midwest Finance Association. He spoke at the prestigious Chautauqua Institution during the summers of 2011 and 2012 as an invited lecturer. At The University of Tennessee, Professor DeGennaro has been nominated for the Allen H. Keally Outstanding Teacher Award, the John B. Ross Outstanding Teaching Award (three times), and the College of Business Outstanding Teaching Award. He has supervised student research at both the graduate and undergraduate levels, serving on dissertation committees and undergraduate honors projects. Professor DeGennaro has presented original research at dozens of professional conferences in North America and abroad. He also has served i on the program committees of several professional organizations and is the recipient of more than 50 research and professional development grants. Professor DeGennaro consults in the areas of business valuation, LQYHVWPHQWVDQG¿QDQFLDOPDQDJHPHQWDQGLVD/XPLQDU\0HPEHURIWKH $QJHO&DSLWDO*URXSŶ ii Table of Contents INTRODUCTION Professor Biography ............................................................................i Course Scope .....................................................................................1 LECTURE GUIDES LECTURE 1 Is Investing in Your Blood? .................................................................3 LECTURE 2 Understanding Fundamental Securities ...........................................10 LECTURE 3 What Is the Stock Market? ...............................................................17 LECTURE 4 Historical Returns and Volatility ........................................................24 LECTURE 5 5LVN([SHFWHG5HWXUQDQG'LYHUVL¿FDWLRQ ......................................32 LECTURE 6 What Determines How Much You’ll Make.........................................39 LECTURE 7 7KH(I¿FLHQW0DUNHW+\SRWKHVLV .......................................................46 LECTURE 8 Choosing a Brokerage Firm..............................................................54 LECTURE 9 Trading and Investing Basics ...........................................................61 LECTURE 10 Trading Strategies and Common Mistakes ......................................68 iii Table of Contents LECTURE 11 The Language of Financial Reporting ..............................................75 LECTURE 12 Corporate Analysis and Valuation .....................................................82 LECTURE 13 Mutual Funds and Other Investment Companies .............................89 LECTURE 14 Minimizing Transaction Costs and Taxes .........................................96 LECTURE 15 Tax Shelters—Roths, IRAs, and 401(k) Plans ................................103 LECTURE 16 Making Sense of IPOs ....................................................................110 LECTURE 17 The Stock Market and the Macro Economy ...................................117 LECTURE 18 ,QYHVWLQJZLWK&RQ¿GHQFH...............................................................124 SUPPLEMENTAL MATERIAL Bibliography ....................................................................................131 iv Disclaimer 7KH ¿QDQFLDO LQIRUPDWLRQ SURYLGHG LQ WKHVH OHFWXUHV LV IRU LQIRUPDWLRQDOSXUSRVHVRQO\DQGQRWIRUWKHSXUSRVHRISURYLGLQJVSHFL¿F ¿QDQFLDO DGYLFH )LQDQFLDO LQYHVWLQJ FDUULHV DQ LQKHUHQW ULVN WKDW \RX ZLOO lose part or all of your investment. Investors must independently and thoroughly research and analyze each and every investment prior to investing. The consequences of such risk may involve but are not limited to: federal/state/municipal tax liabilities, loss of all or part of the investment capital, loss of interest, contract liability to third parties, and other risks not VSHFL¿FDOO\OLVWHGKHUHLQ8VHRIWKHVHOHFWXUHVGRHVQRWFUHDWHDQ\¿QDQFLDO advisor relationship with The Teaching Company or its lecturers, and neither The Teaching Company nor the lecturer is responsible for your use of WKLVHGXFDWLRQDOPDWHULDORULWVFRQVHTXHQFHV<RXVKRXOGFRQWDFWD¿QDQFLDO DGYLVRU WR REWDLQ DGYLFH ZLWK UHVSHFW WR DQ\ VSHFL¿F ¿QDQFLDO LQYHVWLQJ TXHVWLRQV 7KH RSLQLRQV DQG SRVLWLRQV SURYLGHG LQ WKHVH OHFWXUHV UHÀHFW the opinions and positions of the relevant lecturer and do not necessarily UHÀHFWWKHRSLQLRQVRUSRVLWLRQVRI7KH7HDFKLQJ&RPSDQ\RULWVDI¿OLDWHV Pursuant to IRS Circular 230, any tax advice provided in these lectures may not be used to avoid tax penalties or to promote, market, or recommend any matter therein. 7KH 7HDFKLQJ &RPSDQ\ H[SUHVVO\ ',6&/$,06 /,$%,/,7< IRU DQ\ ',5(&7,1',5(&7,1&,'(17$/63(&,$/25&216(48(17,$/ '$0$*(625/267352),76WKDWUHVXOWGLUHFWO\RULQGLUHFWO\IURPWKH use of these lectures. In states that do not allow some or all of the above limitations of liability, liability shall be limited to the greatest extent allowed by law. v Acknowledgments I am indebted to far too many people to mention here. Some, though, provided irreplaceable insights and training either on this project or during my career: x To Gailen Hite, Ed Kane, and Ed Ray for developing the economic intuition necessary to understand new and unfamiliar problems and events. The details of classes and conversations fade with time, but the intuition doesn’t. x To Daniel DeGennaro for proofreading, discussions, and advice about the clarity of the presentations. x 7R'HERUDK+DUUHOO0DUN.DPVWUD/LVD.UDPHUDQG$QG\3XFNHWW for insights and advice. x To my students, friends, and colleagues who at least pretended to be understanding of the time demands this course presented to me. x To the skillful and patient professionals of The Teaching Company who not only tolerated but indulged my many eccentricities. x To Charles Gehring of the New Netherland Project for pronunciation aids. x To Ruth Mullen of H&R Block for tax details. Most of all, I am indebted to the scholars and authors whose research I tapped while preparing these lectures. The investing world would be poorer without their work. —Ray DeGennaro vi How the Stock Market Works Scope: ar too many people think that the stock market is a way to get rich quickly. They think that if they could only uncover the secret workings Fof the stock market, then endless riches will be theirs. That’s a nice dream, but that’s all that it is—a dream. Even worse, trying to get rich quickly usually leads to expensive mistakes. In this course, we’ll learn to avoid those mistakes. Instead of trying to get rich quickly, our goal LVWREHFRPHFRPIRUWDEO\ZHOORIIVORZO\7KDWZD\ZHFDQSOD\WKHJDPH with the odds in our favor. The truth is pretty simple: There’s no free lunch. If a deal sounds too good to be true, then it probably is. If a stock tends to have a big return, then you can be sure that it comes with a big chunk of risk, too. /RWV RI EULOOLDQW SHRSOH EDFNHG E\ SRZHUIXO FRPSXWHUV DQG EOD]LQJ communications networks, spend long hours looking for great deals. They don’t miss much. In fact, we’ll see that the time and effort they spend competing with each other keeps stock prices from getting too far out of line. That means that instead of just being our competitors, they are also our allies. Almost always, the millions of small investors like us get to buy and sell at fair prices. We’ll examine common myths and misconceptions about the way the stock market works. We’ll learn what stocks actually are and how they are traded. We’ll learn about the risks you’ll take if you invest in stocks, and why you PLJKW¿QGEX\LQJWKHPDWWUDFWLYHGHVSLWHWKRVHULVNV Maybe you haven’t even decided that you want to invest in stocks. This course is for you, too, because you’ll learn what you need to know to GHFLGH ,I WKH DQVZHU LV \HV WKHQ \RX¶OO LQYHVW ZLWK PRUH FRQ¿GHQFH DQG avoid mistakes. If the

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