Chapter 1

The
Investment
Environment

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The Investment Environment

• 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 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.

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The Investment Environment
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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

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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
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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

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Types of Investments (cont'd)
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• 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

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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

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Figure 1.1
The Investment Process

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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

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Table 1.1
Overview of Investment Vehicles

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Steps in Investing

• Step 1: Meeting Investment Prerequisites

a. Adequately provide for necessities of life, including
funds for meeting emergency cash needs
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

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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

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Steps in Investing (cont'd)
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• 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

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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

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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)

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Taxes in Investing Decisions
(cont'd)
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• 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

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

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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)

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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

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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

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Investing Decisions
Over Investor Life Cycle
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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

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Investing Decisions
Over Investor Life Cycle (cont'd)
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• 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
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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
Investing in Different
Economic Environments
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Figure 1.2 Different Stages
of an Economic/Market Cycle

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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

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1-25
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

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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

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Chapter 1
Additional
Chapter Art

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

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

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

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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

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Table 1.4 A Scorecard for
Short- Term Investment Vehicles

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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.

1-34