Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 1 The Investment Environment.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 1

The Investment Environment

Copyright © 2008 Pearson Addison-Wesley. 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 investment vehicles.

4. Describe the steps in investing 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.


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


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 an interest in a professionally

managed collection of securities or properties


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


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 1.1 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 and pension funds


Table 1.1 Overview of Investment Vehicles


Steps in Investing

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

funds for meeting emergency cash needsb. Adequate protection against losses from death,

illness and disability

• Step 2: Establishing Investment GoalsExamples include:a. Accumulating retirement fundsb. Enhancing current 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)



• 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


Table 1.2 Tax Rates and Income Brackets for Individual and Joint Returns (2006)



• 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 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


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


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 and mutual funds, government

bonds, quality corporate bonds, bank certificates of deposit


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

– Change in the general direction of the economy’s movement


Figure 1.2 Different Stages of an Economic/Market Cycle


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


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


The Advantages and Disadvantagesof Short-Term Vehicles

• Advantages– High liquidity– Low risks of default

• Disadvantages– Low levels of return– Loss of potential purchasing power

from inflation


Table 1.3 Popular Short-Term Investment Vehicles (Part A)


Table 1.3 Popular Short-Term Investment Vehicles (Part B)


Table 1.3 Popular Short-Term Investment Vehicles (Part C)


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


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 investment vehicles.– Describe the steps in investing and review fundamental

personal tax considerations.– Discuss investing over the life cycle and in different

economic environments.– Understand the popular types of short-term

investment vehicles.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 1 The Investment Environment.

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