BUS 156
Chapter 1
The Investment Environment
What is an Investment?
Investment: any venue that provides an
increase in value, and where 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
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
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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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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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
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 Means
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
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
“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
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Taxes in Investing Decisions
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)
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Taxes in Investing Decisions
 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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Tax Rates and Income Brackets for
Individual and Joint Returns (2006)
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Taxes in Investing Decisions
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)
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Tax-Advantaged Retirement
Plans
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 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
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
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
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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 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
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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
Means
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 Means
Advantages
High liquidity
Low risks of default
Disadvantages
Low levels of return
Loss of potential purchasing power
from inflation
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Popular Short-Term
Investment Means
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Popular Short-Term
Investment Means
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Popular Short-Term
Investment Means
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Investment Suitability
Short-Term Means 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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