Chapter 1 The Investment Environment. Copyright ©2014 Pearson Education, Inc. All rights reserved.1-2 General Information TEXT: Gitman and Joehnk, Fundamentals

Chapter 1

The Investment Environment

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

General Information

• TEXT: Gitman and Joehnk, Fundamentals of Investing, 12th ed. Addison-Wesley, Boston MA.

• MyFinanceLab – Instructor supplies a course code

• The Wall Street Journal or investors Business Daily are good supplemental resources.

• Objective: This course explores some of the basics in investing. We will follow a process of examining the economy, industries and then individual companies. We will explore common stock, bonds, and other common financial instruments.


Course Agenda

Tentative course schedule:– Session I : Chapters 1 - 3– Session II : Chapters 4 - 6– Session III : Chapters 7 – 9,14– Session IV : Chapters 10 - 12– Session V : Chapters 13, 15, 16


Grading

• Exams 50%• Web Exercises 20%• Homework 20%• Attendance and participation

10%• Grades are based on a total point system. The

above weights are approximate


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


Steps in Investing

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

for meeting emergency cash needsb. Adequate protection against various common risks, such

as death, illness, disability

• Step 2: Establishing Investment GoalsExamples include:a. Accumulating retirement fundsb. Enhancing incomec. Saving for major expendituresd. 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 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


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)

Have you ever heard the concern about people getting a pay raise and then complaining because they are in a higher tax bracket? Why is this wrong?


Tax Example

• Don Winsalot and his wife, Lucy, have taxable income of 45K and 70K, respectively. What is the tax liability, if they file single? Joint? What are the average and marginal tax rates?

• Single– Don Lucy

• Joint

279,7)351,35000,45(*25.4867 tax 13529)351,35000,70(*25.4867 tax

20558)701,71000,115(*25.9734 tax

%18.1645000/7279 avgtax %33.1970000/13529 avgtax

%88.17115000/20558 avgtax

No spreadsheet application



• 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)


Capital losses

• This year a person has sustained $12,000 in capital losses. Their other income is $50,000.

• This year they can deduct $3,000 from their other income to determine taxes owed.– They can carry the remaining $9,000 to next year.

• Next year they earn $5,000 in capital gains– $5,000 – 9,000 = -4,000 losses to recover– $3,000 can be used next year to reduce income

for taxation, the remainder is carried forward.


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


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


Table 1.4 A Scorecard for Short-Term Investments


Investment Profile


What is your number for a retirement investment?

What kind of investor are you?

Documents

Chapter 1 The Investment Environment. Copyright ©2014 Pearson Education, Inc. All rights reserved.1-2 General Information TEXT: Gitman and Joehnk, Fundamentals