Chapter 1

The Investment
Environment
 What is an Investment?

• Investment: any asset into which funds

can be placed with the expectation that it
will generate positive income and/or
increase its value
• Return: the reward for owning an
investment
– Income from investment (interest or dividend)
– Increase in value of investment (capital gain)

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 Attributes 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

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 Attributes 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

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 Attributes 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: local-based companies
– Foreign: foreign-based companies

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 Figure 1.2 The Investment Process

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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, cars)
– Typically net suppliers of funds

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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, pension funds

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 Types of Investments

• Short-term Investments
– Conservative investments with lives of 1 year or less
– Provide high liquidity
• Common Stock
– Represents an ownership share of a corporations
– Return comes through dividends and capital gains
• Fixed-income Securities
– Bonds (Coupon or Zero-Coupon)
– Convertible Securities
– Preferred Stock

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 Types of Investments (cont.)
• Mutual funds
– Portfolio of stocks, bonds, or other assets that were
purchased with a pool of funds contributed by many
different investors and that are managed by an investment
company on behalf of its clients.
• Exchange-traded funds (ETFs)
– Similar to mutual funds, ETFs hold portfolios of stocks,
bonds, or other assets. But ETFs can be traded at any
point during the trading session.
• Hedge Funds
– Similar to mutual funds, however hedge funds are only
accessible to a narrower group (accredited investors)
• Derivatives
– Derive their value from an underlying security or assets
– E.g.: options & futures
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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
• 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)

• Step 6: Constructing a Diversified Portfolio

a. Use portfolio comprised of different investments
b. Diversification can increase returns or decrease risks

• Step 7: Managing the Portfolio

a. Compare actual behavior with expected performance
b. Take corrective action when needed

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 Investing Decisions

• Types of Income for Individuals

– Active income: income from working (wages,
salaries, pensions)
– Portfolio income: income from investments
(interests, dividends, capital gains)
– Passive income: income from special
investments (income from real estate, royalties,
limited partnerships)

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 Investing Decisions over
Investor’s Life Cycle

• Investors tend to follow different investment

philosophies as they move through different
stages of life.
• Youth Stage
– Age 20-40
– Growth-oriented investments
– Stress capital gains over current income
– Higher potential growth, higher potential risk
– Examples of investments: common stocks,
options, or futures

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 Investing Decisions over
Investor’s Life Cycle (cont’d)

• Middle-Age Consolidation Stage

– Age 40 to 60
– Family demands & responsibilities become more
important (educational expenses, retirement
savings)
– Move toward less risky investments to preserve
capital
– Transition to higher-quality securities with lower
risk
– Examples of investments: low-risk growth and
income stocks, preferred stocks, convertible
stocks, high-grade bonds, and mutual funds
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 Investing Decisions over
Investor’s Life Cycle (cont’d)

• Retirement Stage
– Age 60 and older
– Preservation of capital and current income
become the primary goal
– Current income needed to supplement retirement
income
– Highly conservative investment portfolio
– Examples of investments: low-risk income stocks
and mutual funds, government bonds, quality
corporate bonds, bank certificate of deposits

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 Investments and the Business
Cycle
• Investments are affected by conditions in the
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
(recovery/expansion) and fall during declining business
cycles (decline/recession)

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 Investments and the Business
Cycle (cont’d)

• Bonds and other forms of fixed-income

securities are also sensitive to the business
cycle.
• Interest rates are the most important
variable in determining returns to investors
for bonds
• Interest rates and bond prices move in
opposite directions
– Interest rates go up → Bond prices go down
– Interest rates go down → Bond prices go up

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 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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 Investment Suitability

• Short-term investments are used for:

– Savings
• Emphasis on safety, liquidity, and convenience, instead
of high yield
– Investment
• Stable return is important
• Used as a component of diversified portfolio
• Used as a temporary outlet while waiting for attractive
long-term investments

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