The Investment Environment
Adequately provide for necessities of life, including
 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
o Current income
o 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
 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
 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
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
Steps in Investing
 Step 1: Meeting Investment Prerequisites
a.
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
 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
 Step 6: Constructing a Diversified Portfolio
a. Use portfolio comprised of different investments
b. 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
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
• 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
• 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
• 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 ageappropriate investments?
– Low-risk income stocks and mutual funds, government
bonds, quality corporate bonds, bank certificates of
deposit
• 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 Disadvantages of Short-Term Vehicles
• Advantages
– High liquidity
– Low risks of default
• Disadvantages
– Low levels of return
– Loss of potential purchasing power from inflation
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

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 Decisions and Interest Rates

• Interest rates are the single most important variable in
determining returns to investors for bonds and fixed-income
securities.