Chapter 1

The Investment
Environment
 What is an Investment?

• Investment: any asset into which funds

can be placed with the expectation that it
will generate positive income and/or
increase its value
• Return: the reward for owning an
investment
– Income from investment
– Increase in value of investment

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-2

 Attributes 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

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-3

 Attributes 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

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-4

 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

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-5

 Figure 1.2 The Investment Process

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-6

 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

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-7

 Types of Investments

• Short-term Investments
– Conservative investments with lives of 1 year or less
– Provide high liquidity
• Common Stock
– Represents an ownership share of a corporations
– Return comes through dividends and capital gains
• Fixed-income Securities
– Bonds (Coupon or Zero-Coupon)
– Convertible Securities
– Preferred Stock

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-8

 Types of Investments (cont.)

• Mutual funds
• Exchange-traded funds (ETFs)
• Hedge Funds
• Derivatives

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-9

 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

Copyright © 2008 Pearson Addison-

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-10
1-10
 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

Copyright © 2008 Pearson Addison-

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-11
1-11
 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

Copyright © 2008 Pearson Addison-

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-121-12
 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

Copyright © 2008 Pearson Addison-

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-131-13
 Investments and the Business Cycle

• Investments are affected by conditions in the

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 by an expanding
business cycle
– Stock prices tend to rise during expanding business cycles
and fall during declining business cycles

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-14

 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

Copyright © 2008 Pearson Addison-

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-15
1-15
 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

Copyright © 2008 Pearson Addison-

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-16
1-16
 Class Activity

• Assume you are leading a team of analysts

at the “I Can’t Believe It’s Fake” Hedge
Fund. If you were given $40,000 of your
client’s funds to invest on their behalf,
develop your investment portfolio (weights)
according to your risk aversiveness. Your
portfolio would consist of the different
securities discussed in today’s lecture.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-17