BUS 156 Chapter 1 The Investment Environment

2 What is an Investment? zInvestment: any venue that provides an increase in value, and where funds can be placed with the expectation that it will generate positive income and/or that its value will be preserved or increased zReturn: the reward for owning an investment yCurrent income yIncrease in value

3 Types of Investments zSecurities or Property ySecurities: stocks, bonds, options yReal Property: land, buildings yTangible Personal Property: gold, artwork, antiques zDirect or Indirect yDirect: investor directly acquires a claim yIndirect: investor owns an interest in a professionally managed collection of securities or properties

4 Types of Investments zDebt, Equity or Derivative Securities yDebt: investor lends funds in exchange for interest income and repayment of loan in future (bonds) yEquity: represents ongoing ownership in a business or property (common stocks) yDerivative Securities: neither debt nor equity; derive value from an underlying asset (options) zLow Risk or High Risk yRisk: chance that actual investment returns will differ from those expected

5 Types of Investments zShort-Term or Long-Term yShort-Term: mature within one year yLong-Term: maturities of longer than a year zDomestic or Foreign yDomestic: U.S.- based companies yForeign: foreign-based companies

6 Suppliers and Demanders of Funds zGovernment yFederal, state and local projects & operations yTypically net demanders of funds zBusiness yInvestments in production of goods and services yTypically net demanders of funds zIndividuals ySome need for loans (house, auto) yTypically net suppliers of funds

7 The Investment Process

8 Types of Investors zIndividual Investors yInvest for personal financial goals (retirement, house) zInstitutional Investors  Paid to manage other people ’ s money yTrade large volumes of securities yInclude: banks, life insurance companies, mutual funds and pension funds

9 Steps in Investing zStep 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 zStep 2: Establishing Investment Goals Examples include: a.Accumulating retirement funds b.Enhancing current income c.Saving for major expenditures d.Sheltering income from taxes

10 Steps in Investing zStep 3: Adopting an Investment Plan a.Develop a written investment plan b.Specify target date and risk tolerance for each goal zStep 4: Evaluating Investment Means a.Assess potential return and risk b.Chapter 4 will cover risk in detail zStep 5: Selecting Suitable Investments a.Research and gather information on specific investments b.Make investment selections

11 Steps in Investing zStep 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) zStep 7: Managing the Portfolio a.Compare actual behavior with expected performance b.Take corrective action when needed

12 Taxes in Investing Decisions  “ It ’ s not what you make, it ’ s what you keep that is important. ” zTax Planning Involves: yThe desired return after-taxes yType of income received from investments yTiming of profit-taking and loss recognition

13 Taxes in Investing Decisions zBasic Sources of Taxes in Investing yFederal: tax rates from 10% to 35% yState taxes zTypes of Income for Individuals yActive Income: income from working (wages, salaries, pensions) yPortfolio Income: income from investments (interest, dividends, capital gains) yPassive Income: income from special investments (rents from real estate, royalties, limited partnerships)

14 Taxes in Investing Decisions zOrdinary Income yActive, portfolio and passive income included yTaxed at progressive tax rates (rates go up as income goes up) zCapital Gains and Losses yCapital Asset: property owned and used by taxpayer, including securities and personal residence yCapital Gain: amount by which the proceeds from the sale of a capital asset are more than its original purchase price yCapital Loss: amount by which the proceeds from the sale of a capital asset are less than its original purchase price

15 Tax Rates and Income Brackets for Individual and Joint Returns (2006)

16 Taxes in Investing Decisions zTaxation of Capital Gains yCapital assets held less than one year: ordinary income tax rates yCapital assets held more than one year: 15% (or 5 %) zTaxation of Capital Losses yCapital losses can be used to offset capital gains yUp to $3,000 per year of capital losses can be used to offset ordinary income (such as wages)

17 Tax-Advantaged Retirement Plans zAllows taxes to be deferred until withdrawn in future zEmployer-sponsored plans yProfit-sharing plans, thrift and savings plans, and 401(k) plans zSelf-employed individual plans yKeogh plans and SEP-IRAs zIndividual plans yIndividual retirement arrangements (IRAs) and Roth IRAs

18 Investing Decisions Over Investor Life Cycle zInvestors tend to follow different investment philosophies as they move through different stages of the life cycle. zYouth Stage yTwenties and thirties yGrowth-oriented investments yHigher potential growth; Higher potential risk yStress capital gains over current income zWhat are some examples of age-appropriate investments? yCommon stocks, options or futures

19 Investing Decisions Over Investor Life Cycle zMiddle-Aged Consolidation Stage yAges 45 to 60 yFamily demands & responsibilities become important (education expenses, retirement savings) yMove toward less risky investments to preserve capital yTransition to higher-quality securities with lower risk zWhat are some examples of age-appropriate investments? yLow-risk growth and income stocks, preferred stocks, convertible stocks, high-grade bonds

20 Investing Decisions Over Investor Life Cycle zRetirement Stage yAges 60 and older yPreservation of capital becomes primary goal yHighly conservative investment portfolio yCurrent income needed to supplement retirement income zWhat are some examples of age- appropriate investments? yLow-risk income stocks and mutual funds, government bonds, quality corporate bonds, bank certificates of deposit

21 Investing in Different Economic Environments zMarket Timing: process of identifying the current state of the economy/market and assessing the likelihood of its continuing on its present course zThree Conditions of the U.S. Economy yRecovery or expansion xCorporate profits are up, which helps stock prices xGrowth-oriented and speculative stocks do well yDecline or recession xValues and returns on common stocks tend to fall  Change in the general direction of the economy ’ s movement

22 Investing Decisions and Interest Rates zInterest rates are the single most important variable in determining returns to investors for bonds and fixed-income securities. zInterest rates and bond prices move in opposite directions: yWhen interest rates go up, bond prices go down yWhen interest rates go down, bond prices go up

23 The Role of Short-Term Means zLiquidity: the ability of an investment to be converted into cash quickly and with little or no loss in value zPrimary use is for emergency cash reserve or to save for a specific short-term financial goal

24 The Advantages and Disadvantages of Short-Term Means zAdvantages yHigh liquidity yLow risks of default zDisadvantages yLow levels of return yLoss of potential purchasing power from inflation

25 Popular Short-Term Investment Means

26 Popular Short-Term Investment Means

27 Popular Short-Term Investment Means

28 Investment Suitability zShort-Term Means are used for: ySavings xEmphasis on safety and security instead of high yield yInvestment xYield is often as important as safety xUsed as component of diversified portfolio xUsed as temporary outlet waiting for attractive permanent investments