Chapter 1

The Investment Environment

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The Investment Environment

Learning Goals
1. Understand the term investment and factors used to differentiate types of investments. 2. Describe the investment process and types of investors. 3. Discuss the principal types of investments. 4. Describe the steps in investing, review fundamental tax issues, and discuss investing over the life cycle. 5. Describe the most common types of short-term investments. 6. Describe the role of investments in some of the main finance related careers.

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What is an Investment?
Investment: any asset into which funds can be placed with the expectation that it will generate positive income and/or preserve or increase its value

Return: the reward for owning an investment

Income from investment Increase in value of investment

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Types of Investments
Securities or Property
Securities: stocks, bonds, options Real Property: land, buildings Tangible Personal Property: gold, artwork, antiques, collectables

Direct or Indirect
Direct: investor directly owns a claim on a security or property Indirect: investor owns an interest in a professionally managed collection of securities or properties

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Figure 1.1 Direct Stock Ownership by Households

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Types of Investments (cont'd)

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: the uncertainty surrounding the return that a particular investment will generate

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Types of Investments (cont'd)

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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Figure 1.2 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 peoples money Trade large volumes of securities Include: banks, life insurance companies, mutual funds, pension funds

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Table 1.1 Major Types of Investments

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Steps in Investing
Step 1: Meeting Investment Prerequisites
a. Adequately provide for necessities of life, including funds for meeting emergency cash needs b. Adequate protection against various common risks, such as death, illness, disability

Step 2: Establishing Investment Goals

Examples include: a. Accumulating retirement funds b. Enhancing income c. Saving for major expenditures d. Sheltering income from taxes

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Steps in Investing (cont'd)

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

Step 4: Evaluating Investment Vehicles

a. Assess potential return and risk b. Chapter 4 will cover risk in detail

Step 5: Selecting Suitable Investments

a. Research and gather information on specific investments b. Make investment selections

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Steps in Investing (cont'd)

Step 6: Constructing a Diversified Portfolio
a. Use portfolio comprised of different investments b. Diversification can increase returns or decrease risks (Chapter 5 will cover diversification in detail)

Step 7: Managing the Portfolio

a. Compare actual behavior with expected performance b. Take corrective action when needed

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Taxes in Investing Decisions

Its not what you make, its 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 (cont'd) 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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Table 1.2 Tax Rates and Income Brackets for Individual and Joint Returns (2009)

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Taxes in Investing Decisions (cont'd)

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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Taxes in Investing Decisions (cont'd) 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 Retirement Vehicles

Allows taxes to be deferred until withdrawn in future Employer-sponsored plans Self-employed individual plans
Keogh plans and SEP-IRAs

Profit-sharing plans, thrift and savings plans, and 401(k) plans

Individual plans

Individual retirement arrangements (IRAs) and Roth IRAs

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Investing Over the Life Cycle

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

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Investing Over the Life Cycle (cont'd)

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

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

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Investing Over the Life Cycle (cont'd)

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

What are some investments for each stage?

Growth-oriented: Common stocks, options or futures Middle-age: Low-risk growth and income stocks, preferred stocks, convertible stocks, high-grade bonds Income-oriented: Low-risk income stocks and mutual funds, government bonds, quality corporate bonds, bank certificates of deposit
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Investments and the Business Cycle

Investments are affected by conditions in the U.S. economy The business cycle reflects the current status of several common economic indicators: gross domestic product (GDP), industrial production, disposable income, unemployment rate A strong economy is reflected by an expanding business cycle
Stock prices tend to rise during expanding business cycles and fall during declining business cycles

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Investments and the Business Cycle (contd) Bonds and other forms of fixed-income securities are also affected by the business cycle since their values are tied to interest rates, which are affected by economics conditions Interest rates and bond prices move in opposite directions

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The Role of Short-Term Investments 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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Advantages and Disadvantages of Short-Term Investments Advantages

High liquidity Low risks of default

Disadvantages
Low levels of return Loss of potential purchasing power from inflation

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Careers in Finance
Commercial banking employs more people than any other part of financial services industry Corporate finance requires broad understanding of functional areas of a business Financial planning professionals in this area often acquire the Certified Financial Planner certification Insurance usually involves risk management or asset management

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Careers in Finance (cont'd)

Investment banking assists organizations in raising capital Investment management involves managing money for clients
practitioners often have the Certified Financial Analyst (CFA) certification example CFA questions appear at the end of each part of this text

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Chapter 1

Additional Chapter Art

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Table 1.3 Popular Short-Term Investments (Part A)

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Table 1.3 Popular Short-Term Investments (Part B)

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Table 1.3 Popular Short-Term Investments (Part C)

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Investment Suitability
Short-Term investments are used for:
Savings
Emphasis on safety and security instead of high yield

Investment
Yield is often as important as safety Used as component of diversified portfolio Used as temporary outlet waiting for attractive permanent investments

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Table 1.4 A Scorecard for Short-Term Investment Vehicles

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Chapter 1 Review
Learning Goals 1. Understand the term investment and factors used to differentiate types of investments. 2. Describe the investment process and types of investors. 3. Discuss the principal types of investments. 4. Describe the steps in investing, review fundamental tax issues, and discuss investing over the life cycle. 5. Describe the most common types of short-term investments. 6. Describe the role of investments in some of the main finance related careers.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

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