The Role

and Scope
of
Investment
s
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

• 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 people’s
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

• 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 inInvesting
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

• 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

• 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

• 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 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 age-
appropriate 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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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 Roleof 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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Table 1.3 Popular Short-
Term Investment Vehicles
(Part A)

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Table 1.3 Popular Short-
Term Investment Vehicles
(Part B)

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Table 1.3 Popular Short-
Term Investment Vehicles
(Part C)

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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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