The Investment Environment

Learning Goals
1. Understand the meaning of the term investment and
list the attributes that distinguish one investment from
Chapter 1 another.
2. Describe the investment process and types of investors.
3. Discuss the principal types of investments.
The Investment 4. Describe the purpose and content of an investment
Environment policy statement, review fundamental tax
considerations, and discuss investing over the life cycle.
5. Describe the most common types of short-term
investments.
6. Describe some of the main careers available to people
with financial expertise and the role that investments
play in each.

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Investments and the Investment Investments and the Investment

Process Process
• Attributes of Investments
The goal of investing is to grow your money to – Securities or Property
achieve long-term financial goals. • Securities: financial assets, such as stocks, bonds,
– Investment: any asset into which funds can be placed and options, that represent claims on the resources of
with the expectation that it will generate positive income the issuer
and/or increase its value • Liquidity: the ability to buy and sell quickly
– Portfolio: a collection of different investments • Property: real assets that are typically less liquid than
securities
– Return: reward from investing – Real property: permanently affixed to the land, such as
land, buildings, and machines
• Income from investment – Tangible personal property: such as gold, artwork,
antiques, and collectables
• Increase in value of investment
– Direct or Indirect
• Attributes of Investments • Direct Investment: investor directly acquires a
claim/ownership
• The Structure of the Investment Process • Indirect Investment: investor indirectly acquires a
claim/ownership via a professional investment manager
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Figure 1.1 Direct Stock Investments and the Investment

Ownership by Households Process
• Attributes of Investments
– Debt, Equity, or Derivative Securities
• Debt: investor lends funds in exchange for interest
income and repayment of loan in future (bonds)
• Equity: ongoing ownership in a business or property
(common stocks)
• Derivative Securities: neither debt nor equity; derive
value from an underlying asset (options)
– Low- or High-Risk Investments
• Risk: uncertainty surrounding the return that a
particular investment will generate
– Low-risk: more predictable, lower average return
– High-risk: less predictable, higher average return
• Diversification: holding different types of assets in an
investment portfolio

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 Investments and the Investment Investments and the Investment
Process Process
• Attributes of Investments • The Structure of the Investment Process
– Short- or Long-Term Investments – Suppliers and Demanders of Funds
• Short-Term: maturities of one year or less • Households
• Long-Term: maturities of longer than one year – Some need for loans (house, auto)
– Typically net suppliers of funds
– Domestic or Foreign
• Government
• Domestic: securities issued by domestic companies – Federal, state and local projects & operations
• Foreign: securities issued by foreign companies – Typically net demanders of funds
• Businesses:
– Investments in production of goods and services
– Typically net demanders of funds

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Investments and the Investment Figure 1.2 The Investment

Process Process
• The Structure of the Investment Process
– Bringing Together Suppliers and Demanders of Funds
• Financial Markets: markets in which suppliers and
demanders of funds trade financial assets, typically
with the assistance of intermediaries such as securities
brokers and dealers
• Financial Institutions: organizations, such as banks
and insurance companies, that pool the resources of
suppliers of funds and use those funds to make loans
to and invest in securities issued by demanders of
funds

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Investments and the Investment

Types of Investments
Process
• The Structure of the Investment Process Investors have a large variety of investments to
– Types of Investors choose from to achieve their investment goals.
• Individual Investors: individuals that manage their • Short-Term Investments
own funds to achieve their financial goals
– Usually concentrate on earning a return on idle funds,
• Common Stock
building a source of retirement income, and providing • Fixed-Income Securities
security for their families
• Mutual Funds
• Institutional Investors: investment professionals
who earn their living by managing other people’s • Exchange-Traded Funds
money • Hedge Funds
– Professionals that trade large volumes of securities for
individuals, as well as for businesses and governments • Derivatives Securities
– Includes banks, life insurance companies, mutual funds, • Other Popular Investments
pension funds, and hedge funds

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 Types of Investments Types of Investments

• Short-term Investments • Mutual funds

– Investments with lives of 1 year or less and little risk – Actively or passively managed portfolio of securities
• US Treasury Bills created by pooling the funds of many different investors
– Provide high liquidity – Allow investors to construct diversified portfolios without
investing a lot of money
• Common Stock
– Money market mutual funds, or money funds, are
– Represents an ownership share of a corporation mutual funds that invest solely in short-term investments.
– Return comes through dividends and capital gains
• Exchange-traded funds (ETFs)
• Fixed-income Securities – Like mutual funds, except ETF shares trade on exchanges,
– Bonds are long-term fixed-income securities issued so investors can buy and sell them at any time that
corporations and governments exchanges are open for trading
– Convertible securities are special debt securities that can • Hedge Funds
be converted into stock
– Funds that pool resources from different investors, but
– Preferred Stock represents an ownership claim, but has no usually have higher minimum investments and are less
maturity and pays a fixed dividend regulated than mutual funds

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Types of Investments Types of Investments

• Derivatives • Other Popular Investments

– Securities that derive their value from some underlying – Tax-advantaged investments: investments that provide
asset (e.g., a share of stock or a commodity) higher after-tax returns by reducing the amount of taxes
that investors must pay.
– Include options and futures contracts
• Municipal bonds
• Options: securities that give the investor an – Real estate: assets such as residential homes, raw land,
opportunity to sell or buy another security at a specified and income property (warehouses, office and apartment
price over a given period of time. buildings, and condominiums).
• Futures: legally binding obligations stipulating that the • Potential returns in the form of rental income, tax write-
seller of the futures contract will make delivery and the offs, and capital gains.
buyer of the contract will take delivery of an asset at a – Tangibles: investment assets, other than real estate, that
specific date and at a price agreed on at the time the can be seen or touched. Purchased in anticipation of price
contract is sold. increases.
• Gold or other precious metals
• Collectibles

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Table 1.1 Major Types of

Making Your Investment Plan
Investments
Developing a well thought-out investment plan
encourages you to follow a disciplined approach to
managing money that will help you to avoid many
common investment mistakes. A good investment
plan is a reminder of goals and a strategic roadmap to
guide investment decisions over a lifetime.
• Writing an Investment Policy Statement
• Considering personal taxes
• Investing over the life cycle
• Investing over the business cycle

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 Making Your Investment Plan Making Your Investment Plan

• Writing an Investment Policy Statement • Considering Personal Taxes

– Summarize your current situation – Basic sources of taxation
• List assets you currently own • Federal, state, and local
• Current income and spending habits • Income, sales, and property
• Define your investment horizon – Types of Income
– Specify your investment goals • Three basic categories of ordinary income:
• Investment goals: financial objectives you wish to – Active Income: income from working (wages,
achieve by investing salaries, pensions)
– Articulate your investment philosophy – Portfolio Income: income from investments (interest,
dividends, capital gains)
• Risk tolerance
– Passive Income: income from special investments (rents
– Set investment selection guidelines from real estate, royalties, limited partnerships)
– Assign responsibility for selecting and monitoring • Taxed at progressive tax rates (rates go up as income
investments goes up)

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Table 1.2 Federal Income Tax Rates and

Brackets for Individual and Joint Returns Making Your Investment Plan
(Due By April 15, 2015)

• Considering Personal Taxes

– 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 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
• Capital Loss: amount by which the proceeds from the sale
of a capital asset are less than its original purchase price
– 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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Making Your Investment Plan Making Your Investment Plan

• Considering Personal Taxes • Investing over the Life Cycle

– Investments and taxes – Investors tend to follow different investment philosophies as
they move through different stages of the life cycle.
• Tax planning: looking at your current and projected
earnings and developing strategies to defer and
minimize the level of taxes.
• Tax plan should achieve maximum after-tax returns for
an acceptable level of risk.
– Tax-Advantaged Retirement Savings Plan – Growth-oriented youth: portfolio tends to favor growth-
• Allows taxes to be deferred until withdrawn in future oriented and speculative investments; particularly high-risk
common stocks
– Employer sponsored plans: profit-sharing, thrift and
– Middle-age consolidation: portfolio shifts to less risky
savings, and 401(k)
investments such as stocks that offer a balance between
– Self-employed individual plans: Keogh and SEP-IRAs growth and income
– Individual plans: Individual retirement arrangements – Income-oriented retirement: portfolio becomes highly
(IRAs) and Roth IRAs conservative to preserve capital and current income in low-
risk income stocks and mutual funds, bonds, etc.
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 The Business Cycle
Making Your Investment Plan

• Investing over 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 in an expanding business
cycle
• Stock prices tend to rise during expanding business
cycles and fall during declining business cycles
– 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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Meeting Liquidity Needs with Meeting Liquidity Needs with

Short-Term Investments Short-Term Investments
Planning for and providing for adequate liquidity, in • The Role of Short-Term Investments
the event of unexpected expenses or opportunities for – Primary function is to provide a pool of reserves for
example, is an important part of an investment plan. emergencies of simply to accumulate funds for some
specific purpose.
Liquidity: the ability to convert an investment into – Short-term investments earn either a stated rate of
cash quickly with little or no loss in value. interest or earn interest on a discount basis,
• The Role of Short-Term Investments • Discount basis: you buy a security at a price below its
redemption value and the difference between what you
• Common Short-Term Investments pay to acquire the asset and what you are paid when it
• Investment Suitability matures is the interest the investment will earn (E.g.,
U.S. Treasury bills, or T-bills).
– Advantages and Disadvantages:
• Advantages: high liquidity, low risk of default
• Disadvantages: low levels of return, loss of potential
purchasing power from inflation
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Table 1.3 Common Short-Term Table 1.3 Common Short-Term

Investments (Part A) Investments (Part B)

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 Table 1.3 Common Short-Term Meeting Liquidity Needs with
Investments (Part C) Short-Term Investments
• Investment Suitability
– Short-Term investments 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
– To decide which securities are most appropriate for a
particular situation, you need to consider such
characteristics as availability, safety, liquidity, and rate of
return.

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Table 1.4 A Scorecard for Short-

Careers in Finance
Term Investment
A career in finance, regardless of the job title,
requires you to understand the investment
environment. Some of the industries with
investments-oriented career opportunities are:
• Commercial banking
• Corporate finance
• Financial planning
• Insurance
• Investment Banking
• Investment Management

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Careers in Finance Careers in Finance

• Commercial banking – employs more people than • Investment management – involves managing
any other part of financial services industry money for clients
• Corporate finance – requires broad understanding – practitioners often have the Chartered Financial Analyst
of functional areas of a business (CFA) certification
– example CFA questions appear at the end of each part of
• Financial planning – professionals in this area often this text
acquire the Certified Financial Planner® certification
• Insurance – usually involves risk management or
asset management
• Investment banking – assists organizations in
raising capital

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 Table 1.5 Average Salaries For Chapter 1 Review: Learning
Various Finance Jobs (2015) Goals
– Understand the meaning of the term investment and list
the attributes that distinguish one investment from
another.
– Describe the investment process and types of investors.
– Discuss the principal types of investments.
– Describe the purpose and content of an investment policy
statement, review fundamental tax considerations, and
discuss investing over the life cycle.
– Describe the most common types of short-term
investments.
– Describe some of the main careers open to people with
financial expertise and the role that investments play in
each.

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