FIN 402 Week 1 Investment Markets and Securities Example

Where Should an $85,000 Inheritance Go First? Comparing Treasury Bills, a Corporate Bond, a Municipal Bond Fund, an Index ETF and One Company's Stock, and How Each Trades

[Student Name]

University of Phoenix

FIN/402: Investment Fundamentals and Portfolio Management

Week 1 Assignment

[Instructor Name]

[Date]

The investor and her choices are composites written for a model paper; market mechanics, costs and research findings come from the sources listed.

Rosa Delgado, a composite 41-year-old respiratory therapist, inherited $85,000 from her aunt. She has a retirement plan at the hospital, an emergency fund of four months' expenses and no debt except a mortgage. She wants the inheritance to grow for retirement, which she hopes to reach at 65, but she has never bought a security directly. A coworker told her to buy shares of the hospital system's largest supplier, whose stock had doubled. Her brother told her to buy Treasury bills because they cannot lose money. Each piece of advice names a security, but neither explains what the security is built to do, which is the first thing an investor needs to know. This paper sets out the choices and how they trade.

Where Securities Come From and Where They Trade

Securities are first sold in the primary market, where a company, a city or the Treasury raises money by issuing stocks or bonds, often with an investment bank's help. After issue, they trade in the secondary market, on exchanges and through dealer networks, where investors buy from and sell to one another (Bodie et al., 2021). The secondary market matters to Rosa because it gives her liquidity: she can sell later without asking the issuer to repay. The issuer receives money only in the primary sale.

Five Candidates

A six-month Treasury bill yielding about 4.3 percent is a money market instrument: short, backed by the federal government and nearly free of default risk. Its weakness is that its yield may barely beat inflation, and rolling it over exposes Rosa to falling rates. A ten-year corporate bond from a utility, yielding about 5.6 percent, pays fixed interest and returns principal at maturity, but its price falls if rates rise, and the issuer could default. A municipal bond fund yielding 3.4 percent pays interest exempt from federal income tax. A stock index exchange-traded fund holds the 500 large companies of the S&P 500 and offers ownership in their profits, with returns that can be strongly negative in any one year. A single supplier's stock carries the same kind of risk plus the risk of that one company.

Comparing Taxable and Tax-Free Yields

Rosa's federal marginal tax rate is 24 percent. The municipal fund's 3.4 percent yield equals a taxable yield of 3.4 divided by 0.76, or about 4.47 percent. That is above the Treasury bill's yield, although Treasury interest is exempt from state tax, which narrows the gap in her state. It is below the corporate bond's 5.6 percent, which compensates for credit risk as well as taxes.

How a Trade Works

Rosa would open a brokerage account and place orders. A market order buys immediately at the best available price, while a limit order sets the highest price she will pay and may not fill. The ETF might be quoted at a bid of $512.40 and an ask of $512.44; she buys at the ask and would sell at the bid, so the four-cent spread is a small trading cost. For a thinly traded municipal bond, spreads can be several dollars per $1,000 of face value, which is one reason individuals often hold municipal bonds through funds.

Margin and Short Selling

Her broker offered a margin account, allowing her to borrow up to half the cost of stock purchases. Borrowing magnifies gains and losses. If she bought $40,000 of the supplier's stock with $20,000 of her own money, and the broker's maintenance margin is 25 percent, a margin call would arrive if the price fell by one third, since her equity would then be $6,667 on a $26,667 position. A short sale, selling borrowed shares in the hope of buying them back cheaper, carries losses with no upper limit. Neither belongs in a first portfolio.

Funds Versus Single Securities

Mutual funds and ETFs pool money across many securities. An S&P 500 index ETF with an expense ratio of 0.03 percent costs $15 a year on $50,000, while an actively managed fund charging 0.85 percent costs $425. If both earned 7 percent before fees for 25 years, the index fund would grow $50,000 to about $269,000 and the active fund to about $222,000, a gap of roughly $47,000. French (2008) estimated that investors in the United States spent close to 0.67 percent of the market's value each year on fees and trading costs in pursuit of beating the market, a cost that index investors largely avoid.

The Pull of Trading

Rosa's coworker recommended a stock that had doubled, and buying recent winners and trading often is a common habit. Barber and Odean (2000) examined the accounts of roughly 66,000 households over six years; the households that turned over their holdings most often earned net annual returns well below those who traded least, largely because of trading costs. A buy-and-hold approach with diversified funds avoids that drag.

A First Step

Rosa's goal is long-term growth, and her emergency fund already covers short-term needs. A sensible first step would place most of the $85,000 in a broad stock index ETF and a smaller share in a bond fund, buying with limit orders and holding in a taxable account with low turnover. The Treasury bill suits money she will need within a year, and the single supplier stock, if she wants it, should stay a small share. Week 3's work on asset allocation will set the exact split.

Investor Protection

Her brokerage account is covered by the Securities Investor Protection Corporation if the broker fails, up to set limits, though that coverage does not protect against market losses. Securities sold to the public are registered with the Securities and Exchange Commission, which requires disclosure but does not judge whether an investment is wise.

Conclusion

Each candidate security does a different job: Treasury bills offer safety, bonds offer income with rate and credit risk, municipal funds offer tax-free income and stocks offer growth with volatility. Understanding how they trade, what they cost and how borrowing changes their risk lets Rosa choose by purpose rather than by tip.

References

Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. The Journal of Finance, 55(2), 773-806. https://doi.org/10.1111/0022-1082.00226

Bodie, Z., Kane, A., & Marcus, A. J. (2021). Investments (12th ed.). McGraw Hill.

French, K. R. (2008). Presidential address: The cost of active investing. The Journal of Finance, 63(4), 1537-1573. https://doi.org/10.1111/j.1540-6261.2008.01368.x