Chapter 1

The Role and

Scope of
Investments

The Role and Scope of Investments

Learning Goals
1. Understand the term investment and how to differentiate
among 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, especially establishing
investing goals 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 part of a portfolio
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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

Domestic or Foreign
Domestic: U.S.-based companies
Foreign: overseas-based companies

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Key Participants
in Investment Process
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 manager other peoples money
Typically manage large amounts of money
Include: banks, life insurance companies,
mutual funds and pension funds
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Steps in Investing
Step 1: Meeting Investment Prerequisites
a. Make certain necessities of life are provided for
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
(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)

Major 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 (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: 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 Vehicles

Allows taxes to be deferred until withdrawn
in future
Employer-sponsored plans
Profit-sharing plans, thrift and savings plans,
and 401(k) plans

Individual plans
Individual retirement arrangements (IRAs)
and Roth IRAs

Self-employed individual plans

Keogh plans, SEP-IRAs, SIMPLE-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 ageappropriate 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 ageappropriate 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 ageappropriate investments?

Low-risk income stocks, 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

Uncertainty

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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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