Chapter 1
The Investment
Environment
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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 investments.
4. Describe the steps in investing, review fundamental tax
issues, and discuss investing over the life cycle.
5. Describe the most common types of short-term
investments.
6. Describe the role of investments in some of the main
finance related careers.
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What is an Investment?
• Investment: any asset into which funds can be
placed with the expectation that it will generate
positive income and/or preserve or increase its
value
• Return: the reward for owning an investment
– Income from investment
– Increase in value of investment
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Types 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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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: the uncertainty surrounding the return that a
particular investment will generate
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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
• 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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Figure 1.2 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, pension funds
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Table 1.1 Major Types of Investments
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Steps in Investing
• Step 1: Meeting Investment Prerequisites
a. Effectively provide for necessities of life, including funds for
meeting emergency cash needs
b. Sufficient 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 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 contained 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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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
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Taxes in Investing Decisions (cont'd)
• 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)
– Portfolio Income: income from investments (interest,
dividends, capital gains)
– Passive Income: income from special investments
(rents from real estate, limited partnerships)
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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
• 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 (cont’d)
• 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
• Rising interest rates are unfavorable for bonds
already held in an investor’s portfolio.
• High interest rates enhance the attractiveness of
new bonds because these bonds must offer high
returns to attract investors.
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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
• Some individuals choose to hold short term
vehicles because they simply don’t want to take
the risk inherent in many types of long term
investments
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Interest on short term investments
• Short terms earn interest in one of the two ways.
• Some investments, such as saving accounts pay
a stated rate of interest. In this case, it’s the
stated rate on the account.
• Some short term investments earn interest on a
discount basis, that means the security is
purchased at a price below its redemption value (
or face value)
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Interest on short term investments
• The difference between what you pay to acquire
the asset and what you receive when it matures
is the interest the investment will earn
• U.S treasury bills ( T-Bills) for example are issued
on a discount basis
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Risk characteristics
• Short term investments are generally considered
low in risk , their primary risk results from inflation
risk- the loss of potential purchasing power.
• That occurs when the rate of return on these
investment falls short of the inflation rate.
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Risk characteristics
• The risk of default- nonpayment- is almost
nonexistent with short term investments, the
reason is that issuers of most short term vehicles
are highly trustworthy institutions such as large
banks and major corporations
• The value of short term investments doesn’t
change much in response to changing interest
rate, exposure to capital loss is low.
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Advantages and Disadvantages of Short-Term
Investments
• Advantages
– High liquidity
– Low risks of default
• Disadvantages
– Low levels of return
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