Chapter One
Prepared by
Victor Abraham
American InterContinental University, Los Angeles
&
DeVry University, West Hills, California
The Investment Setting
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McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Forms of Investment
Financial Assets
1 Equity claims-direct
Common stocks
Warrants
Options
2 Equity claims-indirect
Mutual funds
Pension funds
Whole life insurance
Retirement accounts
Real Assets
Real estate
Office building
Apartments
Shopping centers
Personal residence
Precious metals
Gold
Platinum
Silver
Continued
2
Financial Assets
3 Creditor claims
Savings account
Money market funds
Commercial paper
Treasury bills, notes, bonds
Municipal notes, bonds
Corporate bonds
4 Preferred stock
Real Assets
Precious gems
Diamonds
Rubies
Sapphires
Emeralds
Collectibles
Art
Antiques
Stamps
Coins Continued
3
Financial Assets
Real Assets
5 Commodity
Futures
Options
Options on futures
Other
Cattle
Oil
Common metals
6 Foreign Currency
Cash
Futures
Forward contracts
Leases
Equipment
Machinery
Real estate
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The setting of investment objectives
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Risk and Safety of Principal
Current Income versus Capital Appreciation
Liquidity Considerations
Short-Term versus Long-Term Orientation
Tax Factors
Ease of Management
Retirement and Estate Planning
Considerations
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Risk and Safety of Principal

A BIG QUESTION: What
factors can you think of that
can affect the value of your
portfolio?
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ANSWER:

Everything that happens during the day can
affect the value of your portfolio, e.g.
•
•
•
•
A snow storm in the Midwest
Congressional testimony by Alan Greenspan
A surprise earnings announcements
Anything to do with
 Finance
 Economics
 Legal issues
 Investors’ psychology
 New scientific discoveries
 Politics
 War
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Risk

Variability in the expected return
• High return with high risk
 Aggressive investors
 pork belly options or futures
• Low return with low risk
 Conservative investors
 Bank Saving accounts, CD’s, T-Bills,
T-Notes, and T-Bonds
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Current Income versus Capital
Appreciation (trade-off)

Current income
• Objective: Income NOT growth
EXAMPLES Bond Interests and stock dividends
 High-yielding utilities, mature industries, …

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Capital appreciation
• Objective: Price gains NOT income
EXAMPLES Increase in value - NO cash dividends
 High growth industries

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Liquidity Considerations
Ability to convert
an investment quickly
into cash
at fair market value
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Other Liquidity Factors

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Transaction costs
Commissions
Difference between the “bid” and “ask” price
Alternative investment opportunities with
higher/unusual expected returns
• Arbitrage
EXAMPLES – (with hindsight!) IPO’s of
Microsoft
 Amazon.com
 eBay

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Short-Term versus Long-Term
Orientation

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Short term (one year or less)
Intermediate term (between 1 to 10 years)
Long term (over 10 years)
Diversification in the maturity dates of
investments
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SHORT TERM PESPECTIVE

Traders
• Technical analysis
 Market indicator series
 Charting
 Moving averages
 Ceilings, floors, turning points,…
N.B.: Short term for a trader could be counted in hours,
or even in seconds i.e. buy and sell (or “sell short”
and buy) in one day
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LONG TERM PESPECTIVE

Long term investors
• Buy and hold investors
• Fundamental analysis
Growth rate in sales, market share,…
 Earnings per share (EPS), profit margin,…
 Analyzing the Financial Statement
(Balance sheet, income statement, & cash
flow)

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Tax Factors

High tax brackets
• Municipal bonds (tax free)
• Real estate (depreciation & interest
write-offs
• Tax credits
• Tax shelters
• Tax Relief Act of 2003
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The Bush Tax Relief Act of 2003
Please click on the hyperlink icons
Jobs & Growth Tax
Relief Reconciliation
Act of 2003
Six examples of the Tax
effect in Acrobat
2003 Tax Relief Act
How will it affect you?
Quicken/TurboTax
estimator/calculator
www.ustreas.gov
www.ustreas.gov
www.planningtips.com
www.turbotax.com
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

Reduction in Tax Rates on Dividends and
Capital Gains: The maximum tax rate on
dividends paid by corporations to individuals
and on individuals’ capital gains is reduced to
15% in 2003 through 2008. For taxpayers in the
10% and 15% ordinary income tax rate
brackets, the rate on dividends and capital gains
is reduced to 5% in 2003 through 2007, and to
zero in 2008.
The new rates apply to capital gains realized on
or after May 6, 2003, and to dividends received
in 2003 and after. This provision reduces the
double taxation of corporate earnings. Tax
Relief: CY 2003: $8 billion.
Please click on the link for the FULL PRESS RELEASE
www.ustreas.gov/press/releases
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Ease of Management

Trade-offs between “professional
investment managers” and “do-it-yourself
approach”
•
•
•
•
•
Manager’s fee versus possible higher return
Opportunity costs
Time needed to analyze, choose, & manage
Psychic income
Leisure time
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Retirement and Estate Planning
Considerations


When is the best time to start a retirement
plan?
As early as possible
• TAX BENEFIT
• COMPOUNDING EFFECT

Other factors:
• Personal or family obligations
• Legal issues
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EXAMPLE - Calculating the dollar
Amount of Retirement Funds
Using Excel
Please click on the Excel icon
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Inflation


The rate at which the general level of
prices for goods and services is rising, and
subsequently, purchasing power is falling.
As inflation rises, every dollar will buy a
smaller percentage of a good.
Example - if the inflation rate is 2%, then a
$1 pack of gum will cost $1.02 in a year.
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Inflation – Why should I worry?
Impact of 6% inflation over 20 years
2001 Price
2021 Price
Average automobile
$18,000
$61,110
Mercedes Benz
$42,000
$134,694
Typical 3-bedroom house
$130,000
$416,910
BBA starting salary
$42,000
$142,590
MBA starting salary
$85,000
$272,590
Tuition private college/year
$15,000
$57,715
Ivy League annual tuition
$32,000
$102,624
Poverty level (family of 4)
$36,000
$122,220
Please click on Excel icon– sample calculation
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Measures of
Risk and Return
CALCULATING THE RATE OF
RETURN IN PERCENTAGE
(Ending Value - Beginning value)  Income
Rate of return 
Beginning value
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( P1  P0 )  D1
Rate of return 
P0
P1 = Price at the end of the period
P0 = Price at the beginning of the period
D1 = Dividend income
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RISK – comparing investments

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Uncertainty associated with outcomes
from an investment
The higher the risk, the higher the
expected return (compensation)
Greater uncertainty displayed with wider
dispersion (i.e. higher variance and higher
standard deviation)
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RISK – of a security relative to the
market expressed as beta
beta β
Implication
β=1
Move in tandem with the market
β >1
More risk than the market
β <1
Less risk than the market
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Actual Consideration of
Required Return
1.
2.
3.
The real rate of return.
The anticipated inflation factor.
The risk premium.
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Real Rate of Return


The return investors require for allowing
others to use their money
The annual percentage return realized
on an investment
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Anticipated Inflation Factor

Inflation factor added to the real rate
of return
Risk free rate  (1  Real rate)(1  Expected rate of inflation) - 1
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Risk Premium

Extra return over the risk free rate to
compensate for market risk
A higher rate of return is required to entice
investors into a riskier investment
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Three Key Components of
Total Required Rate of Return
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Real rate of return
Anticipated inflation
Risk Premium
Combine to provide
risk-free rate
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Three Key Components of
Total Required Rate of Return



Real rate of return
Anticipated inflation
Risk Premium
Combine to provide
risk-free rate
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Appendix 1A: Career Opportunities
in Investments
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Stockbroker
Security Analyst
Portfolio Manager
Mergers and Acquisitions
Investment Banker
Financial Planner
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WEBSITE
COMMENT
http://www.aaii.org/
A non profit website educating do it yourself
investors.
www.nasdaq.com
Provides information about Nasdaq stocks
and bonds.
www.nyse.com
Provides information about New York Stock
Exchange, listings and regulations.
www.nareit.com
Provides information and data about real
estate investment trusts.
www.quicken.com
Provides understandable coverage of
financial planning and investing
www.amex.com
Provides information about corporate and
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government bonds.
WEBSITE
COMMENT
www.investopedia.com
Provides a general education site
about stock and investing.
www.tradearca.com
Clients: institutions, Nasdaq Market Makers, broker/dealers and
professional trading accounts. Retail investors cannot send orders
directly to Archipelago. However, retail investors can contact their
brokerage firms to see if they route orders to Archipelago.
www.dfin.com
Provides job search links, loan
calculator, financial links, and
educational links.
www.investorwords.com Provides links to finance sites and
glossary of finance technology.
www.business.com
Provides a searchable database
www.ebrut.com
www.attain.com
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WEBSITE
www.morningstar.com
www.bondmarkets.com
www.moneyadvisor.com
www.reuters.com
www.instintnet.com
www.nestrade.com
COMMENT
Contains evaluations of and
information about stocks and mutual
funds.
Provides information about corporate
and government bonds
Provides insurance-based financial
calculators and links to financial
institutions
Contains business and financial
market news for United States and
other countries
Four largest electronic
communication networks ECNs
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