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138

APPENDIX

Glossary of Terms

Bold type within a definition denotes a term also defined in the glossary.

American Depository Receipts (ADR)-Foreign securities traded in the U.S. markets. ADRs represent a stated number of shares of a foreign stock. Many of the larger ADRs are listed on the New York Stock Exchange and most have detailed financial information available in English.

Anchoring Bias-The failure to make sufficient adjustments from an original eamings or other estimate. Especially problematic in complex decisionmaking environments where the original estimate is far off the mark.

Anomaly-An empirical observation that contradicts the prevailing tiieory.

Availability-A mental rule of thumb, or heuristic, by which people "assess the frequency of a class or the probability of an event by the ease with which instances or occurrences can be brought to mind."* For example, most people would say that shark attacks are more probable than being hit by falling airplane parts, since shark attacks receive far more publicity. Yet being killed by falling airplane parts is 30 times more likely than being killed by a shark attack.

Base Rate-The prior probability that some event will occur. An example would be the average return on the stock market over a period of many years. Not to be confused with the case rate. See also availability, heuristics, regression to the mean, representativeness.

Behavioral Finance-The integration of psychology and economics into a new study of financial markets. It seeks to replace efficient markets with a new paradigm that explains anomalies inconsistent with the old paradigm.

* Amos Tversky & Daniel Kahneman, Judgments Under Uncertainty: Heuristics and Biases (Cambridge: Cambridge University Press, 1982).



Beta-The standard academic measure of systematic risk, or maricet risk. It is a measure ofhow much a stock or portfoUo moves up and down as the market moves up and down. A stock or portfolio that fluctuates more than the market is considered to be more risky and has a higher beta. One that fluctuates less is less risky and has a lower beta. Mathemadcally, beta is the co-variance of a stocks or portfolios return with the market return divided by the variance of the market return.

Bid/Ask Spread-The difference between the price an investor is willing to pay for a stock (the bid) and the price a seller is willing to sell it for (the ask, or offer). It can be expressed as a percentage of the bid price.

Big Board-Trade lingo for the New York Stock Exchange.

Book Value, or Net Asset Value-The value of all common stock after deducting all liabilities and preferred shares.

Bubble-A mass speculation in which prices rise out of all proportion to intrinsic worth, only to crash (or "burst") as investors finally come to their senses.

Buy-and-Hold Strategy-Buying a portfolio and tiien holding it without any further buying or selling for a specified period of time.

Capital Asset Pricing Model (CAPM)-A model for the pricing of securities that assumes tiiat a securitys return is related to the market return through volatility as measured by beta.

Capital Structure-The proportion of debt, preferred stock, and equity in the total capital a company employs. The S&P 500 had a 55% debt-to-equity rado as its capital structure in the mid-ninedes.

Case Rate-The probability of an event occurring based on a relatively short recent history. An example would be predicting a high rate of return on technology stocks in the next few years based on their high return in the past few. The likelihc d of such returns repeating is usually given by the base rate, not the case rate. See also availability, heuristics, regression to the mean, representativeness.

Cash Flow-After-tax eamings, adding back depreciation and other noncash charges. It is a measure of a companys real eamings power, as well as an indicator of its financial viability.

Closed-End Fund, or Closed-End Investment Company-Similar to mutual funds except that they do not continuously issue and redeem shares: their number of shares outstanding is fixed. Hence shares of closed-end funds must be bought and sold on the open market rather than direcdy from the issuing company. Many large closed-end funds trade on the New York Stock Exchange.

Cognitive Bias-The tendency to make logical errors when applying intuitive

rules of thumb. See also heuristics. Concept Stock-A company that may or may not have a financial record, but

definitely has a good story to tell. Such stocks usually have high

price/eamings ratios, if they have any eamings at all.



Confidence Level-One hundred percent minus the statistical significance level. A 95% level of confidence is the lowest level considered acceptable for claiming a finding is meaningful rather than simply random chance.

Configural Reasoning-Inte retation of a piece of information depending on its interaction with other inputs. Also called interactive reasoning, it con-u-asts with linear reasoning, in which inputs are evaluated sequentially, without considering their mutual interactions.

Covariance-The extent to which asset prices move together. If two stocks have similar reactions to investment news, their covariance is positive, if they have opposite reactions to events their covariance is negative, and if they are uncorrelated with each other their covariance is zero. See also beta.

Current Assets versus Current Liabilities-Same as current ratio.

Current Ratio-A ratio of current assets to current liabilities. This ratio determines how able the company is to pay its near-term debts-those due in a year or less. For most nonfinancial companies, a current ratio of 2 to 1 or better is considered sound, although this varies from industry to industry.

Debentures-Debt securities that are backed only by the "faith and credit" of

the issuer (as opposed to first or second mortgage bonds, etc., that are

backed by specific assets of the ). Debt-Equity Ratio-The ratio of debt outstanding to equity (the value of all

preferred stock, common stock, eamed and capital su lus). Debt Security-Any security issued by a firm that has the payment of income

and/or principal to the holders set by legal contract (compare equities). Discount Broker-A broker who offers lower commission rates in exchange

for fewer of the additional services offered by traditional ("full service")

brokers.

Dow Jones Industrial Average-An index originated over a century ago that consists of 30 of the largest "blue-chip" companies in the counuy. It is the most commonly followed stock index, though not the most comprehensive.

Eamings Surprise-The difference between a companys quarterly earnings and the analysts consensus forecast, usually expressed as a percentage of actual eamings.

Efficient Market Hypothesis (EMH)-The notion that all securities are priced "rationally" in the market, that is, that all prices "fully reflect" all available information. Proponents of EMH claim that because all information is contained in stock prices it is impossible to "beat the market" without taking on excess risk.

Equally Weighted Retum-The retum on a portfolio in which each stock begins with an equal amount of money invested in it. See also value-weighted return.



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