Chapter 1 INVESTING

Chapter 1

The Investment Environment

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-2

What is an Investment?

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

• Return: the reward for owning an investment

– Income from investment

– Increase in value of investment


Attributes 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


Figure 1.1 Direct Stock Ownership by Households


Attributes 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


Attributes 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


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


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, pension funds


Types of Investments

• Short-term Investments

– Conservative investments with lives of 1 year or less

– Provide high liquidity

• Common Stock

– Represents an ownership share of a corporations

– Return comes through dividends and capital gains

• Fixed-income Securities

– Bonds

– Convertible Securities

– Preferred Stock


Types of Investments (cont.)

• Mutual funds

– Portfolio of stocks, bonds, and other securities created by pooling the funds of many different investors

– Allow investors to construct diversified portfolios without investing a lot of money

• Exchange-traded funds (ETFs)

– Like mutual funds, except ETF shares trade on exchanges, so investors can buy and sell them at any time that exchanges are open for trading

• Hedge Funds

– Funds that pool resources from different investors, but usually have higher minimum investments and are less regulated than mutual funds


Types of Investments (cont.)

• Derivatives

– Include options and futures contracts

– Securities that derive their value from some underlying asset (e.g., a share of stock or a commodity)

• Other Popular Investments

– Real estate

– Tangibles


Table 1.1 Major Types of Investments


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 various common risks, such as death, illness, disability

• Step 2: Establishing Investment GoalsExamples include:

a. Accumulating retirement funds

b. Enhancing income

c. Saving for major expenditures

d. Sheltering income from taxes


Steps in Investing (cont'd)

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

goal

• Step 4: Evaluating Investmentsa.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


Steps in Investing (cont'd)

• Step 6: Constructing a Diversified Portfolioa.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 Portfolioa.Compare actual behavior with expected

performance

b.Take corrective action when needed


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


Taxes in Investing Decisions (cont'd)

• Basic Sources of Taxes in Investing– Federal: tax rates from 10% to 39.6%*

• Note: 39.6% rate is higher than rate prevailing when text went to press, and does not include new 3.8% surtax on investment income for high earners

– 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)


Table 1.2 Tax Rates and Income Brackets for Individual and Joint Returns (2012)



• 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



• Taxation of Capital Gains– Capital assets held less than one year: ordinary income

tax rates

– Capital assets held more than one year: 0%, 15% or 20% depending on income level

– Medicare tax on investment income of 3.8% for high earners

• These reflect new rates enacted after book went to press

• 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)


Tax-Advantaged Retirement Vehicles

• Allows taxes to be deferred until withdrawn in future

• Employer-sponsored plans– Profit-sharing plans, thrift and savings plans, and 401(k)

plans

• Self-employed individual plans– Keogh plans and SEP-IRAs

• Individual plans– Individual retirement arrangements (IRAs) and Roth IRAs


Investing Over the Life Cycle

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


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


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


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


Investments and the Business Cycle (cont’d)

• 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


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


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


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


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 INVESTING

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