Chapter 1 The Investment Environment PDF

Chapter 1 The Investment Environment Copyright © 2008 Pearson Addison-Wesley. All rights reserved. The Investment Environment Learning Goals 1. Understand the term investment and factors used to differentiate types of investments. 2. Describe the investment process...

Chapter 1 The Investment Environment Copyright © 2008 Pearson Addison-Wesley. All rights reserved. The Investment Environment Learning Goals 1. Understand the term investment and factors used to differentiate types of investments. 2. Describe the investment process and types of investors. 3. Discuss the principal types of investment vehicles. 4. Describe the steps in investing and managing personal tax issues. 5. Discuss investing over the life cycle and in different economic environments. 6. Understand the popular types of short-term investment vehicles. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-2 What is an Investment? Investment: any vehicle into which funds can be placed with the expectation that it will generate positive income and/or that its value will be preserved or increased Return: the reward for owning an investment – Current income – Increase in value Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-3 Types of Investments Securities or Property – Securities: stocks, bonds, options – Real Property: land, buildings – Tangible Personal Property: gold, artwork, antiques Direct or Indirect – Direct: investor directly acquires a claim – Indirect: investor owns an interest in a professionally managed collection of securities or properties Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-4 Types 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: chance that actual investment returns will differ from those expected Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-5 Types 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-6 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-7 Figure 1.1 The Investment Process Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-8 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 and pension funds Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-9 Table 1.1 Overview of Investment Vehicles Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-10 Steps in Investing Step 1: Meeting Investment Prerequisites a. Adequately provide for necessities of life, including funds for meeting emergency cash needs b. Adequate protection against losses from death, illness and disability Step 2: Establishing Investment Goals Examples include: a. Accumulating retirement funds b. Enhancing current income c. Saving for major expenditures d. Sheltering income from taxes Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-11 Steps in Investing (cont'd) Step 3: Adopting an Investment Plan a. Develop a written investment plan b. Specify target date and risk tolerance for each goal Step 4: Evaluating Investment Vehicles a. Assess potential return and risk b. Chapter 4 will cover risk in detail Step 5: Selecting Suitable Investments a. Research and gather information on specific investments b. Make investment selections Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-12 Steps in Investing (cont'd) Step 6: Constructing a Diversified Portfolio a. 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 Portfolio a. Compare actual behavior with expected performance b. Take corrective action when needed Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-13 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-14 Taxes in Investing Decisions (cont'd) Basic Sources of Taxes in Investing – Federal: tax rates from 10% to 35% – 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) Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-15 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-16 Table 1.2 Tax Rates and Income Brackets for Individual and Joint Returns (2006) Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-17 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: 15% (or 5 %) 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) Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-18 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-19 Investing Decisions Over Investor Life Cycle Investors tend to follow different investment philosophies as they move through different stages of the life cycle. Youth Stage – Twenties and thirties – Growth-oriented investments – Higher potential growth; Higher potential risk – Stress capital gains over current income What are some examples of age-appropriate investments? – Common stocks, options or futures Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-20 Investing Decisions Over Investor Life Cycle (cont'd) 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 What are some examples of age-appropriate investments? – Low-risk growth and income stocks, preferred stocks, convertible stocks, high-grade bonds Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-21 Investing Decisions Over Investor Life Cycle (cont'd) Retirement Stage – Ages 60 and older – Preservation of capital becomes primary goal – Highly conservative investment portfolio – Current income needed to supplement retirement income What are some examples of age- appropriate investments? – Low-risk income stocks and mutual funds, government bonds, quality corporate bonds, bank certificates of deposit Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-22 Investing in Different Economic Environments Market Timing: process of identifying the current state of the economy/market and assessing the likelihood of its continuing on its present course Three Conditions of the U.S. Economy – Recovery or expansion Corporate profits are up, which helps stock prices Growth-oriented and speculative stocks do well – Decline or recession Values and returns on common stocks tend to fall – Change in the general direction of the economy’s movement Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-23 Figure 1.2 Different Stages of an Economic/Market Cycle Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-24 Investing Decisions and Interest Rates Interest rates are the single most important variable in determining returns to investors for bonds and fixed-income securities. Interest rates and bond prices move in opposite directions: – When interest rates go up, bond prices go down – When interest rates go down, bond prices go up Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-25 The Role of Short-Term Vehicles 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-26 The Advantages and Disadvantages of Short-Term Vehicles Advantages – High liquidity – Low risks of default Disadvantages – Low levels of return – Loss of potential purchasing power from inflation Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-27 Chapter 1 Additional Chapter Art Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Table 1.3 Popular Short-Term Investment Vehicles (Part A) Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-29 Table 1.3 Popular Short-Term Investment Vehicles (Part B) Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-30 Table 1.3 Popular Short-Term Investment Vehicles (Part C) Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-31 Investment Suitability Short-Term Vehicles 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 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-32 Table 1.4 A Scorecard for Short- Term Investment Vehicles Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-33 Chapter 1 Review Learning Goals – Understand the term investment and factors used to differentiate types of investments. – Describe the investment process and types of investors. – Discuss the principal types of investment vehicles. – Describe the steps in investing and review fundamental personal tax considerations. – Discuss investing over the life cycle and in different economic environments. – Understand the popular types of short-term investment vehicles. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 1-34