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
Increase in value of investment

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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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Figure 1.1 Direct Stock Ownership by

Households

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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: 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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Types of Investors
Individual Investors
Invest for personal financial goals
(retirement, house)

Institutional Investors
Paid to manage other peoples 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
Convertible Securities
Preferred Stock

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Types of Investments (cont.)

Mutual funds
Portfolio of stocks, bonds, and other securities created by
pooling the funds of many different investors
Allow investors to construct diversified portfolios without
investing a lot of money

Exchange-traded funds (ETFs)

Like mutual funds, except ETF shares trade on exchanges,
so investors can buy and sell them at any time that
exchanges are open for trading

Hedge Funds
Funds that pool resources from different investors, but
usually have higher minimum investments and are less
regulated than mutual funds
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Types of Investments (cont.)

Derivatives
Include options and futures contracts
Securities that derive their value from some
underlying asset (e.g., a share of stock or a
commodity)

Other Popular Investments

Real estate
Tangibles

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Table 1.1 Major Types of Investments

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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 various common risks, such
as death, illness, disability

Step 2: Establishing Investment Goals

Examples include:
a. Accumulating retirement funds
b. Enhancing 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 Investments

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)

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

Its not what you make, its 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 39.6%*
Note: 39.6% rate is higher than rate prevailing when text
went to press, and does not include new 3.8% surtax on
investment income for high earners

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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Table 1.2 Tax Rates and Income Brackets for

Individual and Joint Returns (2012)

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Taxes in Investing Decisions (cont'd)

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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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: 0%, 15%
or 20% depending on income level
Medicare tax on investment income of 3.8% for high
earners
These reflect new rates enacted after book went to press

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 Over the Life Cycle

Investors tend to follow different investment
philosophies as they move through different stages
of the life cycle.

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Investing Over the Life Cycle (cont'd)

Growth-oriented youth stage

Twenties and thirties

Growth-oriented investments
Higher potential growth; Higher potential risk
Stress capital gains over current income

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

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Investing Over the Life Cycle (cont'd)

Retirement Stage

Ages 60 and older

Preservation of capital becomes primary goal
Highly conservative investment portfolio
Income needed to supplement retirement income

What are some investments for each stage?

Growth-oriented: Common stocks, options or futures
Middle-age: Low-risk growth and income stocks, preferred
stocks, convertible stocks, high-grade bonds
Income-oriented: Low-risk income stocks and mutual
funds, government bonds, quality corporate bonds, bank
certificates of deposit

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Investments and the Business Cycle

Investments are affected by conditions in the U.S.
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
and fall during declining business cycles

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Investments and the Business Cycle

(contd)
Bonds and other forms of fixed-income
securities are also affected by the business
cycle since their values are tied to interest
rates, which are affected by economics
conditions
Interest rates and bond prices move in
opposite directions

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The Role of Short-Term Investments

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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Advantages and Disadvantages of

Short-Term Investments
Advantages
High liquidity
Low risks of default

Disadvantages
Low levels of return
Loss of potential purchasing power from inflation

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Careers in Finance
Commercial banking employs more people than
any other part of financial services industry
Corporate finance requires broad understanding
of functional areas of a business
Financial planning professionals in this area often
acquire the Certified Financial Planner certification
Insurance usually involves risk management or
asset management

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Careers in Finance (cont'd)

Investment banking assists organizations in
raising capital
Investment management involves managing
money for clients
practitioners often have the Certified Financial Analyst
(CFA) certification
example CFA questions appear at the end of each part of
this text

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