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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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

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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)
 Short-Term or Long-Term
 Short-Term: mature within one year
 Long-Term: maturities of longer than a year

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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)
 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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Types of Income
 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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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 (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)
 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 in an 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

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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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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 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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