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The Investment Environment

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1 The Investment Environment
Chapter 1 The Investment Environment

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.

3 Tentative course schedule:
Course Agenda Tentative course schedule: Session I : Chapters Session II : Chapters Session III : Chapters 7 – 9,14 Session IV : Chapters Session V : Chapters , 15, 16

4 Attendance and participation 10%
Grading Exams % Web Exercises 20% Homework % Attendance and participation % Grades are based on a total point system. The above weights are approximate

5 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

6 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

7 Figure 1.1 Direct Stock Ownership by Households

8 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

9 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

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

11 Types of Investors Individual Investors Institutional 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

12 Types of Investments Short-term Investments Common Stock
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

13 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

14 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

15 Steps in Investing Step 1: Meeting Investment Prerequisites
Adequately provide for necessities of life, including funds for meeting emergency cash needs Adequate protection against various common risks, such as death, illness, disability Step 2: Establishing Investment Goals Examples include: Accumulating retirement funds Enhancing income Saving for major expenditures Sheltering income from taxes

16 Steps in Investing (cont'd)
Step 3: Adopting an Investment Plan Develop a written investment plan Specify target date and risk tolerance for each goal Step 4: Evaluating Investments Assess potential return and risk Chapter 4 will cover risk in detail Step 5: Selecting Suitable Investments Research and gather information on specific investments Make investment selections

17 Steps in Investing (cont'd)
Step 6: Constructing a Diversified Portfolio Use portfolio comprised of different investments Diversification can increase returns or decrease risks (Chapter 5 will cover diversification in detail) Step 7: Managing the Portfolio Compare actual behavior with expected performance Take corrective action when needed

18 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

19 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)

20 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?

21 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 No spreadsheet application

22 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

23 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: 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)

24 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.

25 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

26 Investing Over the Life Cycle
Investors tend to follow different investment philosophies as they move through different stages of the life cycle.

27 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

28 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

29 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

30 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

31 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

32 Advantages and Disadvantages of Short-Term Investments
High liquidity Low risks of default Disadvantages Low levels of return Loss of potential purchasing power from inflation

33 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

34 Table 1.4 A Scorecard for Short-Term Investments

35 Investment Profile

36 What is your number for a retirement investment?
What kind of investor are you?


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