Chapter 1 The Investment Environment

The Investment Environment 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 investments. Describe the steps in investing, review fundamental tax issues, and discuss investing over the life cycle. Describe the most common types of short-term investments. Describe the role of investments in some of the main finance related careers.

What is an Investment? Investment: any asset into which funds can be placed with the expectation that it will generate positive income and/or preserve or increase its value Return: the reward for owning an investment Income from investment Increase in value of investment

Types of Investments Securities or Property Direct or Indirect 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

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: the uncertainty surrounding the return that a particular investment will generate

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

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

Figure 1.2 The Investment Process

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

Table 1.1 Major Types of Investments

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

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 Investment Vehicles 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

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

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 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)

Table 1.2 Tax Rates and Income Brackets for Individual and Joint Returns (2009)

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

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)

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

Investments and taxes The opportunity created by the tax laws make tax planning important in the investment process Tax planning involves looking at your earnings, both the current and projected, and developing strategies that will defer and minimize the level of taxes The tax plan should guide your investment activities so that over the long run, you will achieve maximum after tax returns for an acceptable level of risk

Investments and taxes Investments that are likely to lead capital gains, generally have higher risk than those that provide only current investment income The level of both return and risk need to be viewed in the light of their tax effects. It is the after tax return and associated risk that matter.

Tax- advantaged retirement vehicles The federal government over the years has established a number of types of retirement vehicles, those that are employer sponsored include profit sharing plan, thrift and savings plans and 401 (k) plans. These plans are often voluntary and allow employees to both increase the amount of money held for retirement and enjoy attractive tax deferral benefits.

Tax- advantaged retirement vehicles Keogh plans and SEP-IRAs for self employed people. Individual retirement account (IRA) both deductible and nondeductible and both IRAs, can be setup by just about anybody subject to certain specifications. In general, these plans allow individual to defer taxes, typically on both the contributions and the earnings on them, until retirement.

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 Rising interest rates are unfavorable for bonds already held in an investor’s portfolio. High interest rates enhance the attractiveness of new bonds because these bonds must offer high returns to attract investors.

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 Some individuals choose to hold short term vehicles because they simply don’t want to take the risk inherent in many types of long term investments

Interest on short term investments Short terms earn interest in one of the two ways. Some investments, such as saving accounts pay a stated rate of interest. In this case, you can easily fine the interest rate, it’s the stated rate on the account. Some short term investments earn interest on a discount basis, that means the security is purchased at a price below its redemption value ( or face value)

Interest on short term investments The difference between what you pay to acquire the asset and what you receive when it matures is the interest the investment will earn U.S treasury bills ( T-Bills) for example are issued on a discount basis

Risk characteristics Short term investments are generally considered low in risk , their primary risk results from inflation risk- the loss of potential purchasing power. That occurs when the rate of return on these investment falls short of the inflation rate. Such as the passbook saving, the traditional bank savings account that pay a low interest rate and have no minimum balance. Most other short term investments have rates of return that are slightly higher than the inflation rate

Risk characteristics The risk of default- nonpayment- is almost nonexistent with short term investments, the reason is that issuers of most short term vehicles are highly reputable institutions such as large banks and major corporations The value of short term investments doesn’t change much in response to changing interest rate, exposure to capital loss is low.

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

Careers in Finance Commercial banking – employs more people than any other part of financial services industry Corporate finance – requires broad understanding of functional areas of a business Financial planning – professionals in this area often acquire the Certified Financial Planner® certification Insurance – usually involves risk management or asset management

Careers in Finance (cont'd) Investment banking – assists organizations in raising capital Investment management – involves managing money for clients practitioners often have the Certified Financial Analyst (CFA) certification example CFA questions appear at the end of each part of this text

Careers in Finance Commercial banking : commercial banks provide banking services to individuals and businesses alike. In spite of considerable consolidation within the banking sector, more people work in commercial banking than in any other area of financial services industry. Due to the vast range of services provided by commercial banks, there exists a huge range of finance career opportunities within commercial banking

Careers in Finance Some of the finance related areas found within commercial banks include mortgage lending, corporate lending, asset management, leasing, consumer credit, trade credit and international finance. Some of the job titles common in the commercial banking sector include personal banker, portfolio manager, short term securities manager, financial analysts ,corporate loan officer.

Careers in Finance Corporate finance: the top finance job within a corporation is the Chief financial officer (CFO) The CFO’s primary responsibilities are to manage the firm’s capital resources and capital investments. Managing the firm capital resources includes managing its internal financing such as cash and retained earnings and interacting with financial markets to acquire external financing such as debt or equity.

Careers in Finance Financial planning: a financial planner consults clients on how to deal with their specific situations and meet their specific goals, both short and long term. When consulting with individuals, a personal financial planner provides advice relating to education, retirement and such matters. Business owners will consult financial planners on issues such as cash flow management, investment planning , risk management and insurance planning

Careers in Finance An ability to clarify objectives, assess risks and develop strategic plans is essential for financial planners. CFP ( certified financial planner) you must pass an exam administrated by the CFP board of standards, the exam covers more than 175 topics in investing and financial planning

Careers in Finance Insurance: The insurance business is a trillion dollar industry that serves both individuals and business client needs. There are two prominent finance jobs in insurance one involves assisting individuals and businesses in managing risks And the second involves risk management, individual and businesses invest in risk management in order to protect themselves from Catastrophic losses or to guarantee certain outcomes.

Careers in Finance While insurers collect fees for the services they provide, their goal is to develop investment strategies intended to neutralize the risk assumed from their clients. The insurance industry has vast sums under management and therefore requires highly trained investment specialists.

Careers in Finance Investment banking: investment banks assist firms and governments when issuing financial securities such as bonds and stocks. They facilitate the purchase of securities by both institutional and retail investors Their in-house security analysts provide research on both equity and fixed income securities They also make markets for financial securities Provide financial advice to manage assets for high net worth individuals, firms, institutions and government

Careers in Finance Investment banks even provide their clients with technical analysis or program trading and consultation on mergers and acquisitions

Careers in Finance Investment management: is all about managing money for clients The role of investment manager includes elements of financial analysis, asset selection, securities selection and investment implementation and monitoring. Most investment management is done on the behalf of a pool of investors whose investment comprise a fund.

Careers in Finance Some common examples of managed funds are pension funds, mutual funds, exchange traded fund and hedge fund. Investment management comes in two basic flavors, passive or active, investment managers engaged in passive investment management simply try to create a portfolio whose performance will mimic that of a major stock index like the standard and poor’s 500.

Careers in Finance Such strategy is so cost effective because the fund doesn’t expend resources trying to analyze stocks to determine which will perform best in the future. If you are an adrenaline junkie, so active investment management is going to satisfy you craving All active investment management strategies share the same overarching goal of earning above average returns

Careers in Finance Some active investment managers take advantage of the latest and most sophisticated quantitative techniques, whereas others rely on well-established analytical methods in addition to the portfolio manager’s instincts. Each manager has his own unique style, many money managers buy and hold fixed income securities including corporate bonds, agency securities, others focus on equities such as small stocks, large caps, and emerging marketing stock

Careers in Finance The chartered financial analyst (CFA) certification is one of the most respected financial certifications, its administrated by the CFA institute, which also administers the certificate in investment performance measurement (CIPM) program, either the CFA or the CIPM will enhance your qualifications for a career in finance.

Chapter 1 Additional Chapter Art

Table 1.3 Popular Short-Term Investments (Part A)

Table 1.3 Popular Short-Term Investments (Part B)

Table 1.3 Popular Short-Term Investments (Part C)

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 Investment Vehicles

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 investments. Describe the steps in investing, review fundamental tax issues, and discuss investing over the life cycle. Describe the most common types of short-term investments. Describe the role of investments in some of the main finance related careers.