investment portfolio management - 02 - gitman

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Chapter 1

The Investment Environment

Copyright © 2011 Pearson Prentice Hall. All rights reserved.1-2

The Investment Environment

• Learning Goals1. 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 investments.

4. Describe the steps in investing, review fundamental tax issues, and discuss investing over the life cycle.

5. Describe the most common types of short-term investments.

6. 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– 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– Typically net demanders of funds

• Individuals– Some need for loans (house, auto)– Typically net suppliers of funds


Figure 1.2 The Investment Process


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, pension funds


Table 1.1 Major Types of Investments


Steps in Investing

• Step 1: Meeting Investment Prerequisitesa. Adequately provide for necessities of life, including funds for

meeting emergency cash needsb. Adequate protection against various common risks, such as

death, illness, disability

• Step 2: Establishing Investment GoalsExamples include:a. Accumulating retirement fundsb. Enhancing incomec. Saving for major expendituresd. Sheltering income from taxes


Steps in Investing (cont'd)

• Step 3: Adopting an Investment Plana. Develop a written investment planb. Specify target date and risk tolerance for each goal

• Step 4: Evaluating Investment Vehiclesa. Assess potential return and riskb. Chapter 4 will cover risk in detail

• Step 5: Selecting Suitable Investmentsa. Research and gather information on specific

investmentsb. Make investment selections


Steps in Investing (cont'd)

• Step 6: Constructing a Diversified Portfolioa. Use portfolio comprised of different investmentsb. Diversification can increase returns or decrease risks

(Chapter 5 will cover diversification in detail)

• Step 7: Managing the Portfolioa. Compare actual behavior with expected performanceb. 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)



• 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



• 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


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


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


Advantages and Disadvantages of Short-Term Investments

• Advantages– 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


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

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 investments.

4. Describe the steps in investing, review fundamental tax issues, and discuss investing over the life cycle.

5. Describe the most common types of short-term investments.

6. Describe the role of investments in some of the main finance related careers.

investment portfolio management - 02 - gitman

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