1. Chapter 1 The Role and Scope of Investments

2. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-2 The Role and Scope of Investments Learning Goals 1.Understand the term investment and how to differentiate among 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, especially establishing investing goals 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.

3. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-3 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

4. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-4 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 part of a portfolio

5. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-5 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

6. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-6 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: overseas-based companies

7. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-7 Key Participants in Investment Process 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

8. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-8 Figure 1.1 The Investment Process

9. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-9 Types of Investors Individual Investors –Invest for personal financial goals (retirement, house) Institutional Investors –Paid to manager other people’s money –Typically manage large amounts of money –Include: banks, life insurance companies, mutual funds and pension funds

10. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-10 Table 1.1 Overview of Investment Vehicles

11. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-11 Steps in Investing Step 1: Meeting Investment Prerequisites a.Make certain necessities of life are provided for 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

12. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-12 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

13. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-13 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

14. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-14 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

15. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-15 Taxes in Investing Decisions (cont'd) Major 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)

16. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-16 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

17. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-17 Table 1.2 Tax Rates and Income Brackets

18. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-18 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)

19. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-19 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 Individual plans –Individual retirement arrangements (IRAs) and Roth IRAs Self-employed individual plans –Keogh plans, SEP-IRAs, SIMPLE-IRAs

20. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-20 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

21. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-21 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

22. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-22 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, government bonds, quality corporate bonds, bank certificates of deposit

23. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-23 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 –Uncertainty

24. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-24 Figure 1.2 Different Stages of an Economic/Market Cycle

25. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-25 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.

26. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-26 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

27. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-27 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

28. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-28 Table 1.3 Popular Short-Term Investment Vehicles (Part A)

29. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-29 Table 1.3 Popular Short-Term Investment Vehicles (Part B)

30. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-30 Table 1.3 Popular Short-Term Investment Vehicles (Part C)

31. Copyright © 2005 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

32. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-32 Table 1.4 Popular Short-Term Vehicles

33. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 1-33 Chapter 1 Homework End-of-Chapter Exercises –Problems (page 31) : P1.1, 1.3. (answers available at the textbook website) –Excel Spreadsheet Review (Page 33): details at the textbook website under Student Resources, Chapter 1. Textbook website http://wps.aw.com/aw_gitman_fundinv_9 –Self-assessment quiz (Student Resources, Chapter 1)