BUS 156

Chapter 1

The Investment Environment

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What is an Investment?

Investment: any venue that provides an increase in value, and where funds can be placed with the expectation that it will generate positive income and/or that its value will be preserved or increased

Return: the reward for owning an investment Current income

Increase in value

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Types of Investments

Securities or Property Securities: stocks, bonds, options Real Property: land, buildings Tangible Personal Property: gold,

artwork, antiques

Direct or Indirect Direct: investor directly acquires a claim Indirect: investor owns an interest in a

professionally managed collection of securities or properties

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Types of Investments

Debt, Equity or Derivative Securities Debt: investor lends funds in exchange for

interest income and repayment of loan in future (bonds)

Equity: represents ongoing ownership in a business or property (common stocks)

Derivative Securities: neither debt nor equity; derive value from an underlying asset (options)

Low Risk or High Risk Risk: chance that actual investment returns will

differ from those expected

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Types of Investments

Short-Term or Long-Term Short-Term: mature within one year Long-Term: maturities of longer than a

year

Domestic or Foreign Domestic: U.S.- based companies Foreign: foreign-based companies

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Suppliers and Demanders of Funds

Government Federal, state and local projects & operations Typically net demanders of funds

Business Investments in production of goods and services Typically net demanders of funds

Individuals Some need for loans (house, auto) Typically net suppliers of funds

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The Investment Process

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Types of Investors

Individual Investors Invest for personal financial goals

(retirement, house)

Institutional Investors Paid to manage other people’s money Trade large volumes of securities Include: banks, life insurance

companies, mutual funds and pension funds

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Steps in Investing

Step 1: Meeting Investment Prerequisitesa. Adequately provide for necessities of life,

including funds for meeting emergency cash needs

b. Adequate protection against losses from death, illness and disability

Step 2: Establishing Investment GoalsExamples include:a. Accumulating retirement fundsb. Enhancing current incomec. Saving for major expendituresd. Sheltering income from taxes

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Steps in Investing

Step 3: Adopting an Investment Plana. Develop a written investment planb. Specify target date and risk tolerance for each goal

Step 4: Evaluating Investment Meansa. Assess potential return and riskb. Chapter 4 will cover risk in detail

Step 5: Selecting Suitable Investmentsa. Research and gather information on

specific investmentsb. Make investment selections

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Steps in Investing

Step 6: Constructing a Diversified Portfolioa. Use portfolio comprised of different investmentsb. Diversification can increase returns or decrease

risks (Chapter 5 will cover diversification in detail)

Step 7: Managing the Portfolioa. Compare actual behavior with expected

performanceb. Take corrective action when needed

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Taxes in Investing Decisions

“It’s not what you make, it’s what you keep that is important.”

Tax Planning Involves: The desired return after-taxes Type of income received from investments Timing of profit-taking and loss recognition

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Taxes in Investing Decisions

Basic Sources of Taxes in Investing Federal: tax rates from 10% to 35% State taxes

Types of Income for Individuals Active Income: income from working (wages,

salaries, pensions) Portfolio Income: income from investments

(interest, dividends, capital gains) Passive Income: income from special

investments (rents from real estate, royalties, limited partnerships)

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Taxes in Investing Decisions

Ordinary Income Active, portfolio and passive income included Taxed at progressive tax rates (rates go up as

income goes up)

Capital Gains and Losses Capital Asset: property owned and used by

taxpayer, including securities and personal residence

Capital Gain: amount by which the proceeds from the sale of a capital asset are more than its original purchase price

Capital Loss: amount by which the proceeds from the sale of a capital asset are less than its original purchase price

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Tax Rates and Income Brackets for Individual and Joint Returns (2006)

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Taxes in Investing Decisions

Taxation of Capital Gains Capital assets held less than one year:

ordinary income tax rates Capital assets held more than one year: 15%

(or 5 %)

Taxation of Capital Losses Capital losses can be used to offset capital

gains Up to $3,000 per year of capital losses can be

used to offset ordinary income (such as wages)

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Tax-Advantaged RetirementPlans

Allows taxes to be deferred until withdrawn in future

Employer-sponsored plans Profit-sharing plans, thrift and savings plans,

and 401(k) plansSelf-employed individual plans

Keogh plans and SEP-IRAsIndividual plans

Individual retirement arrangements (IRAs) and Roth IRAs

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Investing Decisions Over Investor Life Cycle

Investors tend to follow different investment philosophies as they move through different stages of the life cycle.

Youth Stage Twenties and thirties Growth-oriented investments Higher potential growth; Higher potential risk Stress capital gains over current income

What are some examples of age-appropriate investments? Common stocks, options or futures

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Investing Decisions Over Investor Life Cycle

Middle-Aged Consolidation Stage Ages 45 to 60 Family demands & responsibilities become

important (education expenses, retirement savings) Move toward less risky investments to preserve

capital Transition to higher-quality securities with lower risk

What are some examples of age-appropriate investments? Low-risk growth and income stocks, preferred

stocks, convertible stocks, high-grade bonds

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Investing Decisions Over Investor Life Cycle

Retirement Stage Ages 60 and older Preservation of capital becomes primary goal Highly conservative investment portfolio Current income needed to supplement

retirement income

What are some examples of age-appropriate investments? Low-risk income stocks and mutual funds,

government bonds, quality corporate bonds, bank certificates of deposit

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Investing in Different Economic Environments

Market Timing: process of identifying the current state of the economy/market and assessing the likelihood of its continuing on its present course

Three Conditions of the U.S. Economy Recovery or expansion

Corporate profits are up, which helps stock pricesGrowth-oriented and speculative stocks do well

Decline or recessionValues and returns on common stocks tend to fall

Change in the general direction of the economy’s movement

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Investing Decisions and Interest Rates

Interest rates are the single most important variable in determining returns to investors for bonds and fixed-income securities.

Interest rates and bond prices move in opposite directions: When interest rates go up, bond prices go

down When interest rates go down, bond prices go

up

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The Role of Short-Term Means

Liquidity: the ability of an investment to be converted into cash quickly and with little or no loss in value

Primary use is for emergency cash reserve or to save for a specific short-term financial goal

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The Advantages and Disadvantagesof Short-Term Means

Advantages High liquidity Low risks of default

Disadvantages Low levels of return Loss of potential purchasing power

from inflation

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Popular Short-Term Investment Means

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Popular Short-Term Investment Means

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Popular Short-Term Investment Means

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Investment Suitability

Short-Term Means are used for: Savings

Emphasis on safety and security instead of high yield

InvestmentYield is often as important as safetyUsed as component of diversified portfolioUsed as temporary outlet waiting for

attractive permanent investments