Chapter 1

Chapter 1

The Role and Scope of Investments

©2005 Kaplan Financial1-2

Key Topics

Key topics include: investments and the investment

process; investment vehicles; and a summary.


What is an Investment?

An investment is the commitment of funds for a period of time with the expectation of preserving value and/or earning a positive rate of return.

Investments may be securities (stocks, bonds, derivatives) or property.

Investments are either direct or indirect. Investments may be high risk or low risk; short-

or long-term; domestic or foreign.


The Investment Process

The investment process transfers funds from individual and institutional investors-who are suppliers of funds to businesses and governments-who are net demanders of funds

The investment process is vital for economic growth. Rewards for investing may come from either current income or increased value.


Investment Vehicles (1 of 3)

There are numerous types of investment vehicles:

Short-term vehicles generally are those that mature in less than a year. Examples include: T-Bills, CD’s and Commercial Paper.

Stocks offer the potential for capital gains and often also pay a dividend.

Fixed income securities, such as bonds, preferred stock, and convertible securities, offer fixed periodic returns and some capital gains potential.



Derivative securities are options and futures that derive their value from the underlying securities or assets.

Mutual funds are investment companies that invest in any and all of the above investment vehicles.

Other popular investment vehicles are real estate and other tangible investments.



Investments play a major role in fulfilling the financial goals of individuals and institutions and, in a broader sense, in financing the growth and development of our economy.

An investment is any vehicle into which funds can be placed with the expectation that it will generate positive income and/or preserve or increase its value. Types of investments may be described in a number of ways:


Securities and Property

Securities are investments that represent evidence of debt or ownership or the legal right to acquire or sell an ownership interest.

Property investments may be made in real property or in tangible personal property.


Direct or Indirect

Direct investment occurs when the investor directly acquires a claim on a security or property.

Indirect investment occurs when the investor acquires a portion of a portfolio of securities or properties.

A portfolio is a selection of securities or properties, typically constructed to meet one or more investment goals.


Debt, Equity and Derivative Securities Debt (i.e. bond) represents funds lent in

exchange for the receipt of interest income and the promised repayment of the loan.

Equity (common stocks) represents an ongoing ownership interest in a business or property.

Derivative securities (options, futures) are securities that are derive their value from the underlying security or asset.


Low and High Risk

Risk refers to the chance that an investment's value or return will be less than its expected value or return.

Speculation refers to the purchase of high-risk investment vehicles that offer highly uncertain earnings and future value.


Short- and Long-Term Investments Short-term investments typically mature

within one year.

Long-term investments have maturities longer than one year or no maturity at all.


Domestic and Foreign

Domestic investments refer to stocks, bonds, derivative securities and property of US-based companies.

Foreign investments are those of foreign-based companies.


The Structure

The structure of the investment process brings together the suppliers of funds with the demanders of funds.

Financial institutions are organizations that channel the savings of governments, businesses, and individuals into loans or investments.

Financial markets are forums in which suppliers and demanders of funds make financial transactions.


Participants

Government at all levels-federal, state, and local-require vast sums of money to finance long-term projects like public facilities. There are times when governments may be temporary suppliers of funds.

Businesses generally require large sums of money to support operations and have both long- and short-term financial needs, though they may from time to time be net suppliers of funds as well.


Participants (continued)

The role of individuals is significant. They demand funds for the financing of houses and automobiles and other major purchases. Their activities, however, also help satisfy net demands of government and businesses by placing funds in savings, purchasing government and corporate securities, and buying a variety of properties.


Types of Investors

There are two major types of investors, i.e. net suppliers of funds, and they are individual and institutional investors.

(i) Individual investors are those who manage their own funds. Many individuals have large sums of money to invest, but often they may hire professionals to invest on their behalf.

(ii) Institutional investors are investment professionals paid to manage other people's money.


Investment Vehicles

A wide variety of investment vehicles are available to investors, with different maturities, risk-return characteristics, costs, and tax considerations.


Investment Vehicles (continued)

Short-term vehicles are savings instruments that usually have maturities of less than a year with little or no risk. The most commonly used instruments are certificates of deposit (CDs), US Treasury bills, commercial paper, money market mutual funds (MMMFs), and series EE savings bonds.

Liquidity, a term most often associated with short-term investments, is the ability of an investment to be converted into cash quickly and with little or no loss in value.


Common Stock

Common stock is an equity investment representing ownership in a corporation; each share represents a fractional ownership interest in the corporation. Returns on common stock come from dividends and/or capital gains. Dividends are periodic payments made by

most corporations to their shareholders. Capital gains is the amount by which the sale

price of an asset exceeds its purchase price.


Fixed-Income

Fixed-income securities are investment vehicles that offer a fixed periodic return. Some forms offer contractually guaranteed returns.

Bonds are long-term debt instruments (IOUs), issued by corporations and governments, that offer a known interest return plus return of the bond's face value at maturity.


Fixed-Income (continued)

Preferred stock is often referred to as a hybrid security; it pays a dividend which is a fixed percentage of par value. Preferred stock is given preference over common stock dividends of the same corporation.

Convertible securities are fixed-income obligations (bonds or preferred stock) with a feature permitting conversion into a specific number of shares of common stock.


Derivatives

Derivative securities derive their value from that of an underlying security or asset. They typically possess high levels of risk and may provide high levels of return.

Options are securities that give the investor an option to sell or buy another security or property at a specified price over a given period of time. Common types of options are puts and calls, rights, and warrants, all of which will be discussed in greater detail in Chapter 11.


Derivatives (continued)

Futures are legally binding obligations stipulating that the sellers of such contracts will make delivery and the buyers of the contracts will take delivery of a specified commodity or financial instrument at some specific date in the future, at a price agreed on at the time the contract is sold.


Mutual Funds

Mutual Funds are investment companies that raise money from sale of its shares and invest in and professionally manage a diversified portfolio of securities.

Money market mutual funds (MMMFs) are funds that invest solely in short-term investment vehicles.


Other

Other popular investment vehicles include real estate, tangibles and tax-advantaged investments.

Real estate investments are entities such as residential homes, raw land, and income property.

Tangibles are investment assets, other than real estate, than can be seen or touched.

Tax-advantaged investments are investment vehicles and strategies for legally reducing one's tax liability.


The Investment Process

Making investment plans is the first step in the logical progression of many.

The impact of taxes on investment returns must be understood.

Stages of an investor's life cycle and the general economic environment are key inputs when setting goals.


Making Investment Plans

Investing is a process that should be driven by well-developed plans to achieve specific goals. It involves a logical set of steps: Meeting investment Prerequisites Establishing investment goals Adopting an investment plan Evaluating investment vehicles Selecting suitable investments Constructing a diversified portfolio Managing the portfolio


Meeting Investment Prerequisites Make certain that necessities of

life are provided for. Emergency funds Adequate protection against losses

(from death, disability, illness, negligence, property damage)


Establishing Investment Goals What are the financial goals that

one wishes to achieve by investing? Accumulating Retirement Funds Enhancing current income Saving for major expenditures Sheltering income from taxes


Adopting an Investment Plan Written document

Describes how the funds will be invested

Specifies the target date for achieving each investment goal

Specifies the amount of tolerable risk


Evaluating Investment Vehicles

Assess each vehicle’s potential return and risk

Involves asset valuation The use of return and risk to estimate

the worth of an investment vehicle


Selecting Suitable Investments Select the investments that are

consistent with your goals Risk and tax considerations Should offer acceptable levels of

return, risk, and value


Construct a Diversified Portfolio Assemble a portfolio that meets

one or more investment goals The inclusion of a number of

different investment vehicles in a portfolio to increase returns and/or reduce risk


Manage the Portfolio

Measure its actual behavior in relation to expected performance

May need to adjust portfolio weights (by buying or selling securities) to maintain optimal portfolio allocation


Taxes

It is important to consider the tax consequences associated with various investments.

Income taxes at the federal, state, and local levels have the greatest impact on security investments (dividend, interest, capital gains).

Property taxes can have a sizable impact on real estate and other forms of property investment.


Types of Income

Active Wages, salaries, bonuses, alimony

Portfolio Income Interest, dividends, and capital gains from

savings accts., stocks, bonds, mutual funds, options, futures

Passive income Income from real estate, limited partnerships,

and other forms of tax-advantaged investments


Taxes

Ordinary Income tax rates Progressive tax rate structure

Capital Gains and Losses A capital asset is property owned and used by

the taxpayer (securities, real estate, home). Capital gain is the amount by which sale

proceeds exceed the original purchase price Capital losses is an amount in which the

proceeds from the sale of a capital asset is less than its purchase price.


Capital Gains The capital gains rate is 15% if the asset is

held for more than 12 months. This 15% capital gains rate assumes that the taxpayer is

in the 25%, 28%, 33%, or 35% ordinary income tax bracket.

There are income brackets for individual and for joint returns.

For taxpayers in the 15% tax bracket, the capital gain tax on an asset held for longer than 12 months is 5%.

For assets held less than 12 months, capital gains are taxed as ordinary income.


Capital Gains Example Example:

James McFail an investor who is in the 25% tax bracket, sold 500 shares of stock at $12 per share. He originally purchased this stock over 12 months ago at $10 per share. What is the capital gains tax on this transaction?


Capital Gains Solution The total capital gain on this

transaction is $1,000 [500 shares x ($12/share - $10/share)]. This amount will be taxed at the 15% capital gains rate because James is in the 25% tax bracket. Therefore, the capital gains tax is $150 ($1,000 x .15).


Capital Losses Before taxes are calculated, all gains

and losses must be netted out. Up to $3,000 of net losses may be

applied against ordinary income in a year.

Losses that can not be applied in the current year may be carried forward and used to offset future income. This rule is subject to certain conditions.


Tax Planning

Developing strategies that will defer and minimize the level of taxes

The plan should guide the activities so that the investor will achieve the maximum after-tax returns for an acceptable level of risk (over the long run)

It is the after-tax return and associated risk that matter.


Life Cycle Investing

Investing over a life cycle is a phenomenon that mirrors the changes in our lives as we move from the growth-oriented age group of 20-45 year olds to the middle-age consolidation phase occurring from 45-60 into the 60-? age group when additional income may be our most important investment goal.


Life Cycle Investing (continued)

Youth (age 20 to 45) Growth-Oriented

Middle-age (age 45 to 60) Consolidation

Retirement Years (age 60 to ?) Income-oriented


Different Economic Environments Investing in different economic

environments dictate different investment actions.

The economic (market) cycle exhibits three distinct stages: a recovering or expansionary stage; a declining or recessionary stage; and uncertainty which may occur both at the top (peak) and at the bottom (trough).


Investing in Different Economic Environments The investment program should be

flexible so that you can recognize and react to changing economic conditions

The Business Cycle State of recovery or expansion State of decline or recession Uncertainty as to the direction or its

movement


Timing the Market

Market timing, which is the ability to identify the current state of the economy/market and assess the likelihood of its continuing on its present course and invest accordingly, is one of the most hotly debated issues within the investment community.

Stocks and other equity-related securities are considered a good investment when the economy is in a recovery, but have low returns when the economy is in a decline.


The Bond Market

Bond prices and interest rates move inversely. When interest rates rise or are expected to rise, bond prices drop, and conversely when interest rates fall or are expected to fall, bond prices rise.

This makes current bondholders see their bonds drop in price when interest rise, but it may appeal to new bondholders who may find bonds that have reached attractive price levels.


The Real Estate Market

Real estate, other tangible investments, including gold and other precious metals, generally have high returns when the rate of inflation (CPI) goes up.


Stocks and the Business Cycle Equity-related securities are highly

responsive to conditions in the economy

Growth-oriented and speculative stocks tend to do well in strong markets. To a lesser extent, so do low-risk and income-oriented stocks.


Interest Rates

Bonds and other fixed-income securities are highly sensitive to interest rates. Rising rates: Bonds decrease in value Falling rates: Bonds increase in value

High interest rates enhance the attractiveness of new bonds.


Interest Rates (continued)

Stocks Stock prices are generally adversely

affected by rising interest rates Interest expense is a major cost to the firm Higher interest rates increase the discount

rate used in the asset valuation process. Higher interest rates increase the

attractiveness of new bonds. Equity investors may sell their stock (downward pressure on prices) to buy bonds.


Liquidity & Short-Term Investment Vehicles (1 of 4)

The ability to convert an investment into cash quickly with little or no loss in value Short-term investment vehicles

3 to 6 months worth of after-tax income for emergency fund

Low risk, low return Highly liquid



Meeting liquidity needs by investing in short-term securities has to be a prerequisite for implementing the longer term goals in your investment plan.

Short-term investments provide liquidity and generate current income (interest). They can earn this income either through a discount purchase or a direct payment.



A discount purchase occurs when the price is below its redemption or face value.

The difference between purchase price and redemption value is the interest.

The following equation allows one to compute the effective interest rate (bond equivalent yield, or BEY).

BEY = 365/number of days to maturity x (redemption value-purchase price)/current price

US Treasury bills are sold at a discount and are considered risk-free.



Key advantages of short-term investments include their convenience and high liquidity. They are also low risk. Rates on short-term investments vary with inflation.

The key disadvantage of short-term investments is their relatively low rate of return.


Passbook Savings & NOW Accounts The passbook savings account has been

the traditional savings vehicle. It is offered by banks and generally pays a low rate of interest but has no minimum balance. For investing purposes, it is not interesting.

NOW (negotiated order of withdrawal) accounts are checking accounts that pay interest and has no legal minimum balance. Except that, some banks impose their own. Not interesting for investment purposes.


MMDAs and Central Asset Accounts

Money market deposit accounts (MMDAs) offer limited check-writing privileges, has no legal minimum balance, but some banks impose their own.

Central asset account is a comprehensive deposit account that combines checking, investing, and borrowing activities; it automatically sweeps excess balances into short term investment and borrows to meet shortages.


US Treasury Bills

US Treasury bills are issued weekly/monthly by the US government in three-month, six month, and one-year maturities.

This instrument is considered the premier short-term investment for individuals with large liquid balances.

Interest is exempt from state and local income taxes which makes them particularly attractive in states and cities with high income tax rates.


T-Bills

T-bills are available through banks, brokers, or directly from the nearest Federal Reserve Bank or branch.

A minimum $ 10,000 investment is necessary and in increments of $ 1,000 thereafter.

T-bills are bought at a discount with the interest being the difference between purchase price and redemption value at maturity.


T-Bills (continued)

Prices are quoted using the bank discount yield (BDY) method.

BDY = 360/number of days to maturity x (redemption value-current price)/redemption value

The BDY can be converted to the BEY. BEY = 365 x BDY/(360-BDY x number of

days to maturity)


Certificates of Deposit (CDs) Certificates of deposit (CDs) represent

funds which must remain on deposit for a specified period of time. Withdrawals prior to maturity may incur interest penalties.

CDs are not considered as attractive as T-bills for investment purposes due to their lack of liquidity and interest penalty which may be incurred.


CDs (continued)

Brokered CDs are bank CDs sold by stockbrokers. There are advantages to these CDs.

There is no penalty if they are sold before maturity, but there is price volatility.

Yields tend to be higher than on non-brokered CDs, but quality must be considered carefully.


Commercial Paper & Bankers’ Acceptances Commercial paper is short-term, unsecured

promissory notes (IOUs) issued by corporations with very high credit standings.

Usually sold in units of $100,000 or larger, though units of $25,000 maybe available. Maturity is always 270 days or less.

Banker's acceptances are short-term, low-risk investment vehicles arising from bank guarantees of business transactions. They are sold at a discount and generally provide yields slightly below those of CDs and commercial paper. The minimum amount is $100,000.


Money Market Mutual Funds Money market mutual funds (MMMFs) are

mutual funds which pool investors' money and purchase high-yield, short-term securities.

They are sold through brokerage firms or can be bought directly from mutual fund houses and generally have among the highest yields of short-term assets. Depending on the composition of the portfolio-whether it includes T-bills, CDs, commercial paper, or other short-term instruments-the riskiness will vary. Those MMMFs investing only in T-bills will be the lowest yielding and highest quality funds.


Money Market Mutual Funds (continued)

MMMFs are not insured by the FDIC but are covered under SIPC if held at a brokerage house.

They offer check-writing privileges. If invested in T-bills and some federal agency

paper, a portion of interest earned is exempt from state and local income taxation.

MMMFs invested in securities issued by municipalities offer interest exempt from federal and most state and local taxation.


Series EE Savings Bonds

Series EE savings bonds are issued by the US Treasury. They are sold through banks and payroll deduction plans, in varying denominations, at 50% of face value, pay a variable rate of interest tied to US treasury market yields, and are calculated every six months in May and November


Series EE Savings Bonds (continued)

Interest on Series EE bonds is exempt from state and local taxes, and federal tax on interest is deferred until redemption.

Series EE bonds can be rolled over into Series HH bonds and the accumulated interest is further deferred.

These bonds offer some tax-exempt income to certain individuals if the proceeds pay educational expenses.


Selecting Short-Term Investments Selection of suitable short-term

investment vehicles depends on availability safety liquidity yield on average return.


Risk Pyramid In Volume I, page 424, review

Exhibit 15: The Risk Pyramid to illustrate investment vehicle types and the types of risk associated with them.

Chapter 1

Documents

property investments

investments value

investment companies

indirect investment

investment goals

investment professionals

property securities

investment vehicles2