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?