11

Chapter One

The Investment Setting

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Prepared byVictor Abraham

American InterContinental University, Los Angeles&

DeVry University, West Hills, California

22

Forms of InvestmentForms of InvestmentFinancial AssetsFinancial Assets Real AssetsReal Assets

11 Equity claims-directEquity claims-direct

Common stocksCommon stocks

WarrantsWarrants

OptionsOptions

Real estateReal estate

Office buildingOffice building

ApartmentsApartments

Shopping centersShopping centers

Personal residence Personal residence

22 Equity claims-indirectEquity claims-indirect

Mutual fundsMutual funds

Pension fundsPension funds

Whole life insuranceWhole life insurance

Retirement accounts Retirement accounts

Precious metalsPrecious metals

GoldGold

PlatinumPlatinum

SilverSilver

Continued Continued

33

Financial AssetsFinancial Assets Real AssetsReal Assets

33 Creditor claimsCreditor claims

Savings accountSavings account

Money market fundsMoney market funds

Commercial paperCommercial paper

Treasury bills, notes, bondsTreasury bills, notes, bonds

Municipal notes, bondsMunicipal notes, bonds

Corporate bonds Corporate bonds

Precious gemsPrecious gems

DiamondsDiamonds

RubiesRubies

SapphiresSapphires

EmeraldsEmeralds

44 Preferred stockPreferred stock CollectiblesCollectibles

ArtArt

AntiquesAntiques

Stamps Stamps Coins Coins Continued Continued

44

Financial AssetsFinancial Assets Real AssetsReal Assets

55 Commodity Commodity

FuturesFutures

OptionsOptions

Options on futuresOptions on futures

OtherOther

CattleCattle

OilOil

Common metalsCommon metals

66 Foreign CurrencyForeign Currency

CashCash

Futures Futures

Forward contracts Forward contracts

LeasesLeases

EquipmentEquipment

MachineryMachinery

Real estate Real estate

55

The setting of investment objectivesThe setting of investment objectives

Risk and Safety of PrincipalRisk and Safety of Principal Current Income versus Capital AppreciationCurrent Income versus Capital Appreciation Liquidity ConsiderationsLiquidity Considerations Short-Term versus Long-Term OrientationShort-Term versus Long-Term Orientation Tax FactorsTax Factors Ease of ManagementEase of Management Retirement and Estate Planning Retirement and Estate Planning

Considerations Considerations

66

Risk and Safety of PrincipalRisk and Safety of Principal

A BIG QUESTION: What A BIG QUESTION: What factors can you think of that factors can you think of that can affect the value of your can affect the value of your portfolio?portfolio?

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ANSWER:ANSWER: Everything that happens during the day can Everything that happens during the day can

affect the value of your portfolio, e.g.affect the value of your portfolio, e.g.• A snow storm in the MidwestA snow storm in the Midwest• Congressional testimony by Alan GreenspanCongressional testimony by Alan Greenspan• A surprise earnings announcements A surprise earnings announcements • Anything to do withAnything to do with

FinanceFinance EconomicsEconomics Legal issuesLegal issues Investors’ psychologyInvestors’ psychology New scientific discoveriesNew scientific discoveries PoliticsPolitics WarWar

88

RiskRisk

Variability in the expected returnVariability in the expected return• High return with high riskHigh return with high risk

Aggressive investorsAggressive investors pork belly options or futurespork belly options or futures

• Low return with low riskLow return with low riskConservative investorsConservative investorsBank Saving accounts, CD’s, T-Bills, Bank Saving accounts, CD’s, T-Bills, T-Notes, and T-BondsT-Notes, and T-Bonds

99

Current Income versus Capital Current Income versus Capital Appreciation (trade-off)Appreciation (trade-off)

Current incomeCurrent income• Objective: Income NOT growthObjective: Income NOT growth EXAMPLES -EXAMPLES -

Bond Interests and stock dividendsBond Interests and stock dividends High-yielding utilities, mature industries, …High-yielding utilities, mature industries, …

Capital appreciationCapital appreciation • Objective: Price gains NOT incomeObjective: Price gains NOT income EXAMPLES -EXAMPLES -

Increase in value - NO cash dividendsIncrease in value - NO cash dividends High growth industriesHigh growth industries

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Liquidity ConsiderationsLiquidity Considerations

Ability to convert Ability to convert an investment an investment

quickly into quickly into cash cash

at fair market value at fair market value

1111

Other Liquidity FactorsOther Liquidity Factors Transaction costsTransaction costs CommissionsCommissions Difference between the “bid” and “ask” priceDifference between the “bid” and “ask” price Alternative investment opportunities with Alternative investment opportunities with

higher/unusual expected returnshigher/unusual expected returns• ArbitrageArbitrageEXAMPLES – (with hindsight!) IPO’s ofEXAMPLES – (with hindsight!) IPO’s of

MicrosoftMicrosoft Amazon.comAmazon.com eBayeBay

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Short-Term versus Long-Term Short-Term versus Long-Term OrientationOrientation

Short term (one year or less)Short term (one year or less) Intermediate term (between 1 to 10 years)Intermediate term (between 1 to 10 years) Long term (over 10 years)Long term (over 10 years) Diversification in the maturity dates of Diversification in the maturity dates of

investmentsinvestments

1313

SHORT TERM PESPECTIVESHORT TERM PESPECTIVE TradersTraders

• Technical analysis Technical analysis Market indicator seriesMarket indicator seriesChartingChartingMoving averagesMoving averagesCeilings, floors, turning points,…Ceilings, floors, turning points,…

N.B.: Short term for a trader could be counted in hours, N.B.: Short term for a trader could be counted in hours, or even in seconds i.e. buy and sell (or “sell short” or even in seconds i.e. buy and sell (or “sell short” and buy) in one dayand buy) in one day

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LONG TERM PESPECTIVELONG TERM PESPECTIVE

Long term investorsLong term investors• Buy and hold investorsBuy and hold investors• Fundamental analysisFundamental analysis

Growth rate in sales, market share,…Growth rate in sales, market share,… Earnings per share (EPS), profit margin,…Earnings per share (EPS), profit margin,… Analyzing the Financial Statement Analyzing the Financial Statement

(Balance sheet, income statement, & cash (Balance sheet, income statement, & cash flow)flow)

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Tax FactorsTax Factors

High tax bracketsHigh tax brackets• Municipal bonds (tax free)Municipal bonds (tax free)• Real estate (depreciation & interest Real estate (depreciation & interest

write-offswrite-offs• Tax creditsTax credits• Tax sheltersTax shelters• Tax Relief Act of 2003Tax Relief Act of 2003

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The Bush Tax Relief Act of 2003The Bush Tax Relief Act of 2003Please click on the hyperlink iconsPlease click on the hyperlink icons

Jobs & Growth Tax Jobs & Growth Tax Relief Reconciliation Relief Reconciliation Act of 2003Act of 2003

Six examples of the Tax Six examples of the Tax effect in Acrobateffect in Acrobat www.ustreas.govwww.ustreas.gov

2003 Tax Relief Act2003 Tax Relief ActHow will it affect you?How will it affect you? www.planningtips.comwww.planningtips.com

Quicken/TurboTax Quicken/TurboTax estimator/calculatorestimator/calculator

www.turbotax.cwww.turbotax.comom

www.ustreas.gowww.ustreas.govv

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Reduction in Tax Rates on Dividends and Reduction in Tax Rates on Dividends and Capital GainsCapital Gains:  The maximum tax rate on :  The maximum tax rate on dividends paid by corporations to individuals dividends paid by corporations to individuals and on individuals’ capital gains is reduced to and on individuals’ capital gains is reduced to 15% in 2003 through 2008.  For taxpayers in the 15% in 2003 through 2008.  For taxpayers in the 10% and 15% ordinary income tax rate 10% and 15% ordinary income tax rate brackets, the rate on dividends and capital gains brackets, the rate on dividends and capital gains is reduced to 5% in 2003 through 2007, and to is reduced to 5% in 2003 through 2007, and to zero in 2008.  zero in 2008. 

The new rates apply to capital gains realized on The new rates apply to capital gains realized on or after May 6, 2003, and to dividends received or after May 6, 2003, and to dividends received in 2003 and after.  This provision reduces the in 2003 and after.  This provision reduces the double taxation of corporate earnings.  Tax double taxation of corporate earnings.  Tax Relief: CY 2003: $8 billion.Relief: CY 2003: $8 billion.

Please click on the link for the FULL PRESS RELEASEPlease click on the link for the FULL PRESS RELEASE

www.ustreas.gov/press/www.ustreas.gov/press/releasesreleases

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Ease of ManagementEase of Management

Trade-offs between “professional Trade-offs between “professional investment managers” and “do-it-yourself investment managers” and “do-it-yourself approach”approach”• Manager’s fee versus possible higher returnManager’s fee versus possible higher return• Opportunity costsOpportunity costs• Time needed to analyze, choose, & manage Time needed to analyze, choose, & manage • Psychic incomePsychic income• Leisure timeLeisure time

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Retirement and Estate Planning Retirement and Estate Planning ConsiderationsConsiderations

When is the best time to start a retirement When is the best time to start a retirement plan?plan?

As early as possibleAs early as possible• TAX BENEFITTAX BENEFIT• COMPOUNDING EFFECTCOMPOUNDING EFFECT

Other factors:Other factors:• Personal or family obligationsPersonal or family obligations• Legal issuesLegal issues

2020

EXAMPLE - Calculating the dollar EXAMPLE - Calculating the dollar Amount of Retirement Funds Amount of Retirement Funds

Using ExcelUsing Excel

Please click on the Excel iconPlease click on the Excel icon

2121

InflationInflation

The rate at which the general level of The rate at which the general level of prices for goods and services is rising, and prices for goods and services is rising, and subsequently, purchasing power is falling.subsequently, purchasing power is falling.

As inflation rises, every dollar will buy a As inflation rises, every dollar will buy a smaller percentage of a good.smaller percentage of a good.

Example - if the inflation rate is 2%, then a Example - if the inflation rate is 2%, then a $1 pack of gum will cost $1.02 in a year.$1 pack of gum will cost $1.02 in a year.

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Inflation – Why should I worry?Inflation – Why should I worry?Impact of 6% inflation over 20 yearsImpact of 6% inflation over 20 years

2001 Price2001 Price 2021 Price2021 Price

Average automobileAverage automobile $18,000$18,000 $61,110$61,110

Mercedes BenzMercedes Benz $42,000$42,000 $134,694$134,694

Typical 3-bedroom houseTypical 3-bedroom house $130,000$130,000 $416,910$416,910

BBA starting salaryBBA starting salary $42,000$42,000 $142,590$142,590

MBA starting salaryMBA starting salary $85,000$85,000 $272,590$272,590

Tuition private college/yearTuition private college/year $15,000$15,000 $57,715$57,715

Ivy League annual tuitionIvy League annual tuition $32,000$32,000 $102,624$102,624

Poverty level (family of 4)Poverty level (family of 4)Please click on Excel icon– sample calculationPlease click on Excel icon– sample calculation

$36,000$36,000 $122,220$122,220

Measures ofMeasures of Risk and Return Risk and Return

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CALCULATING THE RATE OF CALCULATING THE RATE OF RETURN IN PERCENTAGERETURN IN PERCENTAGE

valueBeginning

Income value)Beginning - Value (Ending return of Rate

2525

PP11 = Price at the end of the period = Price at the end of the period

P P00 = Price at the beginning of the period = Price at the beginning of the period

D D11 = Dividend income = Dividend income

0

101 )( return of Rate

P

DPP

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RISK – comparing investmentsRISK – comparing investments

Uncertainty associated with outcomes Uncertainty associated with outcomes from an investmentfrom an investment

The higher the risk, the higher the The higher the risk, the higher the expected return (compensation)expected return (compensation)

Greater uncertainty displayed with wider Greater uncertainty displayed with wider dispersion (i.e. higher variance and higher dispersion (i.e. higher variance and higher standard deviation)standard deviation)

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RISK – of a security relative to the RISK – of a security relative to the market expressed as betamarket expressed as beta

beta beta ββ ImplicationImplication

ββ = 1 = 1 Move in tandem with the marketMove in tandem with the market

ββ >1 >1 More risk than the marketMore risk than the market

ββ <1 <1 Less risk than the marketLess risk than the market

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Actual Consideration of Actual Consideration of Required ReturnRequired Return

1.1. The real rate of return.The real rate of return.

2.2. The anticipated inflation factor.The anticipated inflation factor.

3.3. The risk premium.The risk premium.

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Real Rate of ReturnReal Rate of Return

The return investors require for allowing The return investors require for allowing others to use their moneyothers to use their money

The annual percentage return realized The annual percentage return realized on an investmenton an investment

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Anticipated Inflation FactorAnticipated Inflation Factor

Inflation factor added to the real rate Inflation factor added to the real rate of returnof return

1- inflation) of rate Expected rate)(1 Real (1 rate freeRisk

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Risk PremiumRisk Premium

Extra return over the risk free rate to Extra return over the risk free rate to compensate for market riskcompensate for market risk A higher rate of return is required to entice A higher rate of return is required to entice investors into a riskier investment investors into a riskier investment

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Three Key Components of Three Key Components of Total Required Rate of ReturnTotal Required Rate of Return

Real rate of returnReal rate of return Anticipated inflationAnticipated inflation Risk PremiumRisk Premium

Combine to Combine to provide risk-free provide risk-free raterate

3333

Three Key Components of Three Key Components of Total Required Rate of ReturnTotal Required Rate of Return

Real rate of returnReal rate of return Anticipated inflationAnticipated inflation Risk PremiumRisk Premium

Combine to Combine to provide risk-free provide risk-free raterate

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Appendix 1A: Career Opportunities Appendix 1A: Career Opportunities in Investmentsin Investments

StockbrokerStockbroker Security AnalystSecurity Analyst Portfolio ManagerPortfolio Manager Mergers and AcquisitionsMergers and Acquisitions Investment BankerInvestment Banker Financial PlannerFinancial Planner

3535

WEBSITEWEBSITE COMMENTCOMMENT

http://www.aaii.org/http://www.aaii.org/ A non profit website educating do it yourself A non profit website educating do it yourself investors.investors.

www.nasdaq.comwww.nasdaq.com Provides information about Nasdaq stocks Provides information about Nasdaq stocks and bonds.and bonds.

www.nyse.comwww.nyse.com Provides information about New York Stock Provides information about New York Stock Exchange, listings and regulations.Exchange, listings and regulations.

www.nareit.comwww.nareit.com Provides information and data about real Provides information and data about real estate investment trusts.estate investment trusts.

www.quicken.comwww.quicken.com Provides understandable coverage of Provides understandable coverage of financial planning and investingfinancial planning and investing

www.amex.comwww.amex.com Provides information about corporate and Provides information about corporate and government bonds.government bonds.

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WEBSITEWEBSITE COMMENTCOMMENTwww.investopedia.comwww.investopedia.com Provides a general education site Provides a general education site

about stock and investing.about stock and investing.

www.tradearca.comwww.tradearca.com Clients: institutions, Nasdaq Market Makers, broker/dealers and Clients: institutions, Nasdaq Market Makers, broker/dealers and professional trading accounts. Retail investors cannot send orders professional trading accounts. Retail investors cannot send orders directly to Archipelago. However, retail investors can contact their directly to Archipelago. However, retail investors can contact their brokerage firms to see if they route orders to Archipelago. brokerage firms to see if they route orders to Archipelago.

www.dfin.comwww.dfin.com Provides job search links, loan Provides job search links, loan calculator, financial links, and calculator, financial links, and educational links.educational links.

www.investorwords.comwww.investorwords.com Provides links to finance sites and Provides links to finance sites and glossary of finance technology.glossary of finance technology.

www.business.comwww.business.com Provides a searchable databaseProvides a searchable database

www.ebrut.comwww.ebrut.com

www.attain.comwww.attain.com

3737

WEBSITEWEBSITE COMMENTCOMMENT

www.morningstar.comwww.morningstar.com Contains evaluations of and Contains evaluations of and information about stocks and mutual information about stocks and mutual funds.funds.

www.bondmarkets.comwww.bondmarkets.com Provides information about corporate Provides information about corporate and government bonds and government bonds

www.moneyadvisor.comwww.moneyadvisor.com Provides insurance-based financial Provides insurance-based financial calculators and links to financial calculators and links to financial institutionsinstitutions

www.reuters.comwww.reuters.com Contains business and financial Contains business and financial market news for United States and market news for United States and other countries other countries

www.instintnet.comwww.instintnet.com Four largest electronic Four largest electronic communication networks ECNscommunication networks ECNs

www.nestrade.comwww.nestrade.com