Chapter1InvestmentEnvironment11

PartOne
PreparingtoInvest
PartOneIncludes
Chapter1

InvestmentEnvironment

Chapter2

MarketsandTransactions

Chapter3

OnlineInformationandInvesting

1Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Chapter1
InvestmentEnvironment
Outline
Learning Goals
I.

InvestmentsandtheInvestmentProcess
A) TypesofInvestments
1. SecuritiesorProperty
2. DirectorIndirect
3. Debt,Equity,orDerivativeSecurities
4. LoworHighRisk
5. ShortorLongTerm
6. DomesticorForeign
B) TheStructureoftheInvestmentProcess
1. ParticipantsintheInvestmentProcess
2. Government
3. Business
4. Individuals
5. TypesofInvestors
ConceptsinReview

II.

InvestmentVehicles
A) ShortTermVehicles
B) CommonStock

C) FixedIncomeSecurities
1. Bonds
2. PreferredStock
3. ConvertibleSecurities
D) MutualFunds
E) DerivativeSecurities
1. Options
2. Futures
F) OtherPopularInvestmentVehicles
ConceptsinReview

3Gitman/JoehnkFundamentalsofInvesting,NinthEdition

III. MakingInvestmentPlans
A) StepsinInvesting
1. MeetingInvestmentPrerequisites
2. EstablishingInvestmentGoals
3. AdoptinganInvestmentPlan
4. EvaluatingInvestmentVehicles
5. SelectingSuitableInvestments
6. ConstructingaDiversifiedPortfolio
7. ManagingthePortfolio
B) ConsideringPersonalTaxes
1. BasicSourcesofTaxation
2. TypesofIncome
a. OrdinaryIncome
b. CapitalGainsandLosses
3. InvestmentsandTaxes
4. TaxadvantagedRetirementVehicles
C) InvestingOvertheLifeCycle
D) InvestinginDifferentEconomicEnvironments
1. StocksandtheBusinessCycle
2. BondsandInterestRates
ConceptsinReview

Chapter1InvestmentEnvironment4

IV. MeetingLiquidityNeeds:InvestinginShortTermSecurities
A) RoleofShortTermSecurities
1. InterestonShortTermSecurities
2. RiskCharacteristics
3. AdvantagesandDisadvantagesofShortTermInvestments
B) PopularShortTermInvestmentVehicles
1. DepositAccounts
2. FederalGovernmentIssues
3. NongovernmentIssues
C) InvestmentSuitability
ConceptsinReview

Summary
PuttingYourInvestmentKnowHowtotheTest
DiscussionQuestions
Problems
CaseProblems
1.1 InvestmentsorGolf?
1.2 PreparingCarolynBowensInvestmentPlan
ExcelwithSpreadsheets
OTISOnlineTradingandInvestmentSimulator

Key Concepts

5Gitman/JoehnkFundamentalsofInvesting,NinthEdition

1.

Themeaningoftheterminvestmentandtheimplicationsithasforindividualinvestors.

2.

Reviewthefactorsusedtodifferentiatebetweendifferenttypesofinvestments.

3.

Theimportanceofandbasicstepsinvolvedintheinvestmentprocess.

4.

Populartypesofinvestmentvehicles,includingshorttermvehicles,commonstock,andfixedincome
securitiessuchasbonds,preferredstock,andconvertibles.

5.

Derivativesecuritiessuchasoptionsandfutures,andmutualfunds.

6.

Otherpopularinvestmentvehiclessuchasrealestate,tangiblesandtaxadvantagedinvestments.

7.

Investmentgoalsincludingincome,majorexpenditures,retirement,andshelteringincomefrom
taxes.Thelatterincludesanalysisoftaxadvantagedretirementvehicles.

8.

Buildingadiversifiedportfolioconsistentwithinvestmentgoals.

9.

Sourcesoftaxation,typesoftaxableincome,andtheeffectoftaxesontheinvestor.

10. Developinganinvestmentprogramthatconsidersdifferingeconomicenvironmentsandlifecycle
stages.
11. Theuseofshorttermsecuritiesinmeetingliquidityneeds.
12. Themeritsandsuitabilityofvariouspopularshortterminvestmentvehiclesincludingdeposit
accountsandmoneymarketsecurities.

Overview
Thischapterprovidesanoverviewofthescopeandcontentofthetext.
1.

Theterminvestmentisdefined,andthealternativeinvestmentopportunitiesavailabletoinvestorsare
classifiedbytypes.

2.

Anexaminationofthestructureoftheinvestmentprocessispresented.Thissectionexplainshow
suppliersanddemandersofinvestmentfundsarebroughttogetherinthemarketplace.

3.

Thekeyparticipantsintheinvestmentprocessgovernment,business,andindividualsare
described,asareinstitutionalandindividualinvestors.

4.

Returnsaredefinedasrewardsforinvesting.Returnstoaninvestortaketwoformscurrentincome
andincreasedvalueoftheinvestmentovertime.Inthissectiontheinstructorneedonlydefinereturn,
sincetherewillbeanotheropportunitytodeveloptheconceptofreturninChapter4,however
providinginformationaboutrecentinvestmentreturnsisalwayswellreceivedbystudents.

Chapter1InvestmentEnvironment6

5.

Next,thefollowinginvestmentvehiclesavailabletoindividualinvestorsarediscussed:shortterm
vehicles,commonstock,fixedincomesecurities,mutualfunds,realestate,tangibles,taxadvantaged
investments,andoptionsandfutures.Thetextdescribestheirriskreturncharacteristicsinageneral
way.Theinstructormaywanttoexpandontheadvantagesanddisadvantagesofinvestingineach,
althoughtheywillbetreatedingreaterdetailinsubsequentchapters.Itisvitalforanyinvestorto
establishinvestmentgoalsthatareconsistentwithhisorheroverallfinancialobjectives.

6.

Oncetheinvestmentgoalshavebeenwellspecified,theinvestorcanadoptaninvestmentplan
consistentwiththesegoals,selectsuitableinvestments,buildadiversifiedportfolioandmanageit.

7.

Personaltaxesarediscussedintermsoftypesofincomeandtaxrates.Theinvestmentprocessis
affectedbycurrenttaxlaws.Examplesoftaxshelters,especiallytaxadvantagedretirementvehicles,
andtaxplanningareprovided.

8.

Onceinvestmentgoalsareestablished,itisimportanttounderstandhowtheinvestmentprocessis
affectedbydifferenteconomicenvironments.Thechaptertalksabouttypesofinvestmentsstocks,
bonds,andtangiblesastheyareaffectedbybusinesscycles,interestrates,andinflation.

9.

Liquidityisdefinedandshorttermsecuritiesthatcanbeusedtomeetliquidityrequirementsare
described.Thediscussionincludesalookatshortterminterestratesandtheriskcharacteristicsof
variousshorttermsecurities.

10. Thenextsectioncoversthevarioustypesofshorttermvehiclesavailabletotodaysinvestor.Thereis
enoughdetailabouteverythingfrompassbookaccountstomoneymarketfundstocommercialpaper
thatthestudentsshouldgetagoodgraspofthedifferencesbetweenthevehicles.Producing
informationoncurrentrateshelpsbringrealismintotheclassroomandenhancesstudentperception
ofthelecturerasaknowledgeableinstructor.

Answers to Concepts in Review

1.

Aninvestmentisanyvehicleintowhichfundscanbeplacedwiththeexpectationofpreservingor
increasingvalueandearningapositiverateofreturn.Aninvestmentcanbeasecurityoraproperty.
Individualsinvestbecauseaninvestmenthasthepotentialtopreserveorincreasevalueandtoearn
income.Itisimportanttostressthatthisdoesnotimplythataninvestmentwillinfactpreservevalue
orearnincome.Badinvestmentsdoexist.

2.

(a) Securitiesandpropertyaresimplytwoclassesofinvestments.Securitiesareinvestments,
commonlyevidencedbycertificates,thatrepresentalegalclaim.Forexample,abondrepresents
alegalclaimondebt,andastockrepresentsaproportionateownershipinthefirm.Anoption,on
theotherhand,representsthelegalrighttoeitherbuyorsellanassetatapredeterminedprice
withinaspecifiedtimeperiod.Propertyconstitutesinvestmentsineitherrealproperty(landand
buildings)ortangiblepersonalproperty(Rembrandtpaintings,Mingvases,orantiquecars).
(b) Withadirectinvestment,anindividualacquiresadirectclaimonasecurityorproperty.For
example,aninvestmentinoneshareofIBMstockdirectlyprovidesthestockholdera
proportionateownershipinIBM.Anindirectinvestmentprovidesanindirectclaimonasecurity
orproperty.Forexample,ifyouboughtoneshareofFidelityGrowthFund(amutualfund),you
areineffectbuyingaportionofaportfolioofsecuritiesownedbythefund.Thus,youwillhave
aclaimonafractionofanentireportfolioofsecurities.

7Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(c) Aninvestmentindebtrepresentsfundsloanedinexchangeforthereceiptofinterestincomeand
repaymentoftheloanatagivenfuturedate.Thebond,acommondebtinstrument,pays
specifiedinterestoveraspecifiedtimeperiod,thenrepaysthefacevalueoftheloan(Chapters8
and9coverbondsindetail).Anequityinvestmentprovidesaninvestoranongoingfractional
ownershipinterestinafirm.Themostcommonexampleisaninvestmentinacompanys
commonstock.WewillstudyequityinstrumentsingreaterdetailinChapters5through7.
Derivativesecuritiesaresecuritiesderivedfromdebtorequitysecuritiesandstructuredtoexhibit
characteristicsdifferentfromtheunderlyingsecurities.Optionsarederivativesecuritiesthat
allowaninvestortosellorbuyanothersecurityorassetataspecificpriceoveragiventime
period.Forexample,aninvestormightpurchaseanoptiontobuyCompanyXstockfor$50
withinninemonths.
(d) Shortterminvestmentstypicallymaturewithinoneyearwhilelongterminvestmentshavelonger
maturities,likecommonstock,whichhasnomaturityatall.However,longterminvestmentscan
beusedtosatisfyshorttermfinancialgoals.
3.

Infinance,riskreferstothechancethatthereturnfromaninvestmentwilldifferfromitsexpected
value.Thebroadertherangeofpossiblevalues(dispersion),thegreatertheriskoftheinvestment.
Lowriskinvestmentsarethoseconsideredsafewithrespecttothereturnoffundsinvestedandthe
receiptofapositiverateofreturn.Highriskinvestmentsarethosewhichhavemoreuncertainfuture
valuesandlevelsofearnings.

4.

Foreigninvestmentsareinvestmentsinthedebt,equity,derivativesecuritiesofforeignbased
companiesandpropertyinaforeigncountry.Bothdirectandindirectforeigninvestmentsprovide
investorsmoreattractivereturnsorlowerriskinvestmentscomparedtopurelydomesticinvestments.
Theyareusefulinstrumentstodiversifyapuredomesticportfolio.

5.

Theinvestmentprocessbringstogethersuppliersanddemandersoffunds.Thismayoccurdirectly(as
withpropertyinvestments).Mostoftentheinvestmentprocessisaidedbyafinancialinstitution(such
asabank,savingsandloan,savingsbank,creditunion,insurancecompany,orpensionfund)that
channelsfundstoinvestmentsand/orafinancialmarket(eitherthemoneymarketorthecapital
market)wheretransactionsoccurbetweensuppliersanddemandersoffunds.

6.

(a) Thevariouslevelsofgovernment(federal,state,andlocal)requiremorefundsforprojectsand
debtrepaymentthantheyreceiveinrevenues.Thus,governmentsarenetdemandersoffunds.
Governmentsalsodemandfundswhenthetimingoftheirrevenuesdonotmatchtheir
expenditure.Thetermnetreferstothefactthat,whilegovernmentsbothsupplyanddemand
fundsintheinvestmentprocess,onbalancetheydemandmorethantheysupply.
(b) Businessesalsoarenetdemanders,requiringfundstocovershortandlongtermoperating
needs.Whilebusinessfirmsoftensupplyfunds,onbalancetheyalsodemandmorethanthey
supply.
(c) Individualsarethenetsuppliersoffundstotheinvestmentprocess.Theyputmorefundsintothe
investmentprocessthantheytakeout.Individualsplayanimportantroleintheinvestment
processsupplyingthefundsneededtofinanceeconomicgrowthanddevelopment.

7.

Institutionalinvestorsareinvestmentprofessionalswhoarepaidtomanageotherpeoplesmoney.
Theyareemployedbyfinancialinstitutionslikebanksandinsurancecompanies,bynonfinancial
businesses,andbyindividuals.Individualinvestorsmanagetheirownpersonalfundsinordertomeet
theirfinancialgoals.Generally,institutionalinvestorstendtobemoresophisticatedbecausethey
handlemuchlargeramountsofmoneyandtheytendtohaveabroaderknowledgeoftheinvestment
processandavailableinvestmenttechniquesandvehicles.

Chapter1InvestmentEnvironment8

8.

Shortterminvestmentvehiclesarethosewhichusuallyhavelivesoflessthanoneyear.These
vehiclesmaybeusedtowarehousetemporarilyidlefundswhilesuitablelongtermvehiclesare
evaluated.Duetotheirsafetyandconvenience,theyarepopularwiththosewishingtoearnareturn
ontemporarilyidlefundsorwiththeveryconservativeinvestorwhomayusetheseshortterm
vehiclesasaprimaryinvestmentoutlet.
Inadditiontotheirwarehousingfunction,shorttermvehiclesprovideliquiditytheycanbe
convertedintocashquicklyandwithlittleornolossinvalue.Thischaracteristicisveryusefulwhen
investorsneedtomeetunexpectedexpensesortakeadvantageofattractiveopportunities.

9.

Commonstockisanequityinvestmentthatrepresentsafractionalownershipinterestinacorporation.
Thereturnonacommonstockinvestmentderivesfromtwosources:dividends,whichareperiodic
paymentsmadebythefirmtoitsshareholdersfromcurrentandpastearnings,andcapitalgains,
whichresultfromsellingthestockatapriceabovetheoriginalpurchaseprice.
Becausecommonstockoffersabroadrangeofreturnriskcombinations,itisoneofthemostpopular
investmentvehicles.Twosourcesofpotentialreturnaredividendsandcapitalgain.

10. (a) Bondsaredebtobligationsofcorporationsorgovernments.Abondholderreceivesaknown

interestreturn,typicallysemiannually,plusthefacevalueatmaturity.Bondsareusuallyissued
in$1,000denominations,paysemiannualinterest,andhavetwentytofortyyearmaturities.
Bondsofferfixed/certainreturns,ifheldtillmaturity.
(b) Preferredstockisverymuchlikecommonstockinthatitrepresentsanownershipinterestina
corporation.Butpreferredstockpaysonlyafixedstateddividend,whichhasprecedenceover
commonstockdividends,anddoesnotshareinotherearningsofthefirm.
(c) Aconvertiblesecurityisafixedincomesecurity,eitherabondorpreferredstock,thathasa
conversionfeature.Typically,itcanbeconvertedintoaspecifiednumberofsharesofcommon
stock.Convertiblesecuritiesarequasiderivativesecuritiesastheirmarketvaluewoulddepend
onthepriceofthecommonstockandtheconversionratio.
(d) Amutualfundisacompanythatinvestsinalargeportfolioofsecurities;whereasamoney
marketmutualfundisamutualfundwhichsolelyinvestsinothershorttermvehicles.Investors
mightfindmutualfundsappealingbecausealargeportfoliomaybemoreconsistentwiththeir
investmentgoalsintermsofriskandreturn.Aswewillseelater,amutualfundoffersthe
investorthebenefitsofdiversificationandprofessionalmanagement.Mutualfundsdonotoffer
fixed/certainreturns.Mutualfundsarequasiderivativesecuritiesastheirmarketvaluewould
dependonthepriceoftheassetsthatmakeupthefundsportfolio.
(e) Optionsarederivativesecuritiesthatprovidesholderstherighttobuyorsellanothersecurity
(typicallystock)orpropertyataspecifiedpriceoveragiventimeperiod.Factorslikethetime
untilexpiration,theunderlyingstockpricebehavior,andsupplyanddemandconditionsaffect
thereturns.
(f) Futuresrepresentcontractualarrangementsinwhichasellerwilldeliverorabuyerwilltake
deliveryofaspecifiedquantityofacommodityatagivenpricebyacertaindate.Unlikean
option,whichgivestheinvestortherighttopurchaseorsellanothersecurity,futurescontracts
obligatetheinvestortodeliverortakedelivery.Factorsaffectingreturnsoncommoditycontracts
includechangesingovernmentpolicy,unpredictableweather,tradeembargoes,andsoon.
11. Beforedevelopingandexecutinganinvestmentprogram,aninvestormustensurethefollowing:
(1) Necessitiesoflifesuchasfundsforhousing,food,transportation,taxesetcarefullyprovidedfor.
(2) Investorisadequatelyinsuredagainstthelossesresultingfromdeath,illnessordisability,
propertyetc.
(3) EstablishRetirementGoals

9Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Thesevenstepsininvestingareasfollows:
(1) MeetingInvestmentPrerequisites:ProvidingforNecessitiesoflife,adequateprotectionagainst
losses,andSettingretirementGoalsasdiscussedabove
(2) EstablishingInvestmentGoals:Investmentgoalsarethefinancialobjectivesthatonewishesto
achievebyinvesting.Commoninvestmentgoalsare:
Accumulatingretirementfunds
Enhancingcurrentincomethroughinterestincomeanddividends
Savingsformajorexpenditurelikehome,educationetc.
Shelteringincomefromtaxes
(3) AdoptinganInvestmentPlan:Awrittendocumentdescribinghowfundswillbeinvestedisan
investmentplan.Themorespecifictheinvestmentgoal,theeasieritwillbetoestablishan
investmentplanconsistentwithyourgoals.
(4) EvaluatingInvestmentVehicles:Inthisstep,themeasuresofriskandreturnareusedtoestimate
theperceivedworthofaninvestmentvehicle.Thisprocessiscalledvaluation.
(5) SelectingSuitableInvestments:Thisstepinvolvescarefulselectionofinvestmentvehiclesthat
areconsistentwithestablishedgoalsandofferacceptablelevelsofreturn,risk,andvalue.
(6) ConstructingaDiversifiedPortfolio:Diversificationistheconceptofformingaportfoliousing
differentinvestmentvehiclestoreduceriskandincreasereturn.Thisconceptiscentralto
constructinganeffectiveportfolio.
(7) ManagingthePortfolio:Portfoliomanagementinvolvesmonitoringtheportfolioand
restructuringitasdictatedbytheactualbehavioroftheinvestments.
12. Investmentgoalsarethefinancialobjectivesyouwishtoachievebyinvestinginanyofawiderange
ofinvestmentvehicles.Commoninvestmentgoalsare:
(a) Enhancingcurrentincomemeanschoosinginvestmentvehiclesthatregularlypaydividendsand
interestthatcanprovideallorsomeofthemoneyneededtomeetlivingexpenses.Thisisa
commongoalofretiredpersonsandsometimesanimportantpartofanormalfamilybudget.
(b) Savingformajorexpendituresincludesmoneysetasideforsuchthingsasthedownpaymenton
ahome,collegetuition,andevenanexpensivevacation.Theamountofmoneyneededandthe
timeperiodoverwhichonecansavewilldeterminetheamountsetasideand,frequently,the
investmentvehicleemployed.
(c) Thesinglemostimportantreasonforinvestingistoaccumulateretirementfunds.Theamount
thatmustbesetasideisdeterminedbythelevelofexpectedexpenditures,expectedincomefrom
socialsecurityandothersources,andtheamountofinterestexpectedtobeearnedonsavings.
(d) Shelteringincomefromtaxesinvolvestakingadvantageofcertaintaxprovisionsthatpermit
reductionoftheincomereportedtothegovernmentordirectreductionsintaxes.Investmentsin
certainassets,suchasrealestate,maybeattractiveduetotheirtaxadvantages.
13. Federalincometaxesarechargedagainstallincomeindividualsreceivefromallsources(withthe
exceptionofinterestreceivedonsomebondsissuedbystateandlocalgovernments).
(a) Active(ordinaryearned)incomeisthebroadestcategoryandincludesincomefromwages,
salaries,bonuses,tips,pensionincome,andalimony.Itismadeupofincomeearnedonthejob
aswellasmostotherformsofnoninvestmentincome.
(b) Portfolio(investment)incomeisearningsgeneratedfromvarioustypesofinvestmentholdings.
Forthemostpart,itconsistsofinterest,dividends,andcapitalgainsearnedonmosttypesof
investments.Passiveincomeisaspecialcategorythatconsistsofincomederivedchieflyfrom
realestate,limitedpartnerships,andotherformsoftaxshelters.

Chapter1InvestmentEnvironment10

(c) Capitalgainsaretheprofitsearnedonthesaleofcapitalassetspleasure,orinvestment.They
aremeasuredbytheamountbywhichtheproceedsfromthesaleofthecapitalassetexceedits
originalpurchaseprice.Currentlycapitalgainsaretaxedatthesamerateasordinaryincome.
Capitalgainsareappealingtoinvestorsbecausetheyarenottaxeduntiltheyareactually
realized.
(d) Acapitallossistheamountbywhichtheproceedsfromthesaleofacapitalassetarelessthan
itsoriginalpurchaseprice.Upto$3,000ofnetlossescanbeappliedagainstordinaryincomein
anyoneyear,withtheunusedportioncarriedforwardtooffsetfutureincome.
(e) Duetotheopportunitiesandchallengescreatedbythetaxlaws,taxplanningisanimportantpart
oftheinvestmentprocess.Taxplanninginvolveslookingatanindividualscurrentandprojected
earningsanddevelopingstrategiesthatwilldeferorminimizethelevelofhisorhertaxes.Tax
plansinvolvecurrentincome,capitalgains,ortaxshelteredinvestments.Forexample,one
strategyistotakelossesastheyoccurandtodelaytakingprofits.Onedeductsthelossesand
delaysinclusionofprofitsinordertominimizecurrenttaxableincome.
(f) Ingeneral,taxadvantagedretirementplansallowindividualstodefertaxesonthecontribution
and/orportfolioearningsuntilsomefuturedatewhenretirementwithdrawalstakeplace.There
areemployersponsoredplans,suchas401(k)accountsandindividualcreatedplans,suchas
Keoghplans,andindividualretirementaccounts(IRAs).
14. (a) Younginvestors,ages20to45,tendtoprefergrowthorientedinvestmentsthatstresscapital
gainsratherthanincome.Theseinvestorshavelittleinvestablefunds,andcapitalgainsareseen
asthequickestwaytobuildupinvestmentcapital.
(b) Bymiddleage,ages45to60,thereisaconsolidationtakingplaceasfamilydemandsand
responsibilitieschange.Whilegrowthorientedsecuritiesarestillused,investingbecomesless
speculative.Qualitygrowthvehiclesareemployed,andmoreattentionisgiventocurrent
income.Thefoundationisbeingsetforretirement.
(c) Astheinvestormovesintotheretirementyears,age60on,preservationofcapitalandcurrent
incomebecometheprincipalconcerns.Highqualitystocksandbondsandmoneymarket
instrumentsareusedastheinvestorsobjectiveistoliveascomfortablyaspossiblefrom
theinvestmentincome.Duringretirementonetriestoreaptherewardsofalifetimeofsaving
andinvesting.
15. Thefourstagesoftheeconomic/marketcyclearerecovery,expansion,decline,andrecession.
Recoveryisthestrengtheningoftheeconomyafterarecession.Expansionreflectscontinuedstrength
andoptimismabouteconomicgrowth.Declineinvolvesaslowingdownoftheeconomyafteran
expansionwhichmayhavebeenmovingtoofast.Thenthecyclemovesintorecession,theeconomy
contractsandpessimismreigns.Justasthingslooktheworst,therecoverycyclebeginsagain.
(a) Stocksandequityrelatedsecurities(suchasmutualfundsandconvertibles)arehighly
responsivetotheeconomiccycle.Duringrecoveryandexpansionstockpricesareup.Asthe
declineapproaches,stockpricesbegintodeclineaswell.Growthorientedandspeculativestocks
tendtodoespeciallywellinanexpandingeconomy.
(b) Bondsandotherfixedincomesecuritiesaresensitivetomovementsininterestrates.Bondprices
alsomoveintheoppositedirectionofinterestratechanges.Thismeansthatifinterestratesare
expectedtorise,bondpriceswouldfall,andbondswouldnotbeagoodplacetoholdinvestment
funds.Interestratesgenerallyshiftwiththeeconomiccycle.Ratesriseduringnormalrecovery
andfallduringeconomicdeclines.

11Gitman/JoehnkFundamentalsofInvesting,NinthEdition

16. Anassetisliquidifitcanbeconvertedtocash(sold)easilyandquickly,withlittleornolossin
value.Youwouldwanttoholdliquidassetsasemergencyfundsortoaccumulatefundsforsome
specificpurpose.IBMstockisnotconsideredaliquidinvestmenteventhoughitcanbeeasilysold.
Aswithstocksingeneral,youcanneverbesurethat,whenfundsareneeded,youcanquicklysellthe
stockwithouttakingaloss.
17. Purchasingpowerriskforshortterminvestmentsoccurswhentherateofreturnontheseinvestments
fallsshortoftheinflationrate.Thisgenerallyhappenstofixedrateinvestmentssuchaspassbook
savingsaccounts.Mostothershortterminvestmentshavemanagedtoprovideratesofreturnabout
equaltotheinflationratewhenonelooksattheseshorttermratesoverlongperiodsoftime.Default
(nonpayment)riskisverysmallwithmostshortterminvestments.Thedepositsinbanksandother
federallyinsuredsavingsinstitutionsareprotectedupto$100,000peraccountbyagenciesofthe
federalgovernment.U.S.TreasuryBillsareperfectlysafeandsometimescalledariskfree
investment.Commercialpaperandrepurchaseagreementsareextremelysafe,baseduponpast
experience,eventhoughtherehavebeenrareinstancesofproblems.Theselattertwoinstrumentsare
alsonotinsured.Moneymarketmutualfundshavealsohadanexceptionallysafehistory.Ofcourse,
thesafestmoneymarketfundsarethosewhichinvestsolelyingovernmentsecuritiesandare
virtuallydefaultriskfree.
18. PassbooksavingsaccountsandNOWaccounts(acheckingaccount),offeredbybanks,generallypay
alowrateofinterestandhavenominimumbalance.PassbooksavingsandNOWaccountsare
primarilyusedbyinvestorsassavingsaccounts,providingtheinvestorwithahighlyliquidpoolof
funds.MMDAsarebankdepositaccountswithlimitedcheckwritingprivileges.Centralasset
accountsarecomprehensivedepositaccountsandcombinechecking,investingandborrowing
activities.MMDAsandassetmanagementaccountsaremorelikelyusedbyinvestorstoearna
competitiveshorttermreturnwhilemaintainingliquidity.Eachtypeofaccount,exceptforasset
managementaccounts,isinsured.Allbutthepassbookaccounttypicallyrequireaminimumbalance
whichvaries.
19. (a) SeriesEEsavingsbondsareaccrualtypesecurities,whichmeansthatinterestispaidwhenthe
bondiscashed,onorbeforematurity,ratherthanperiodicallyoverthelifeofthebond.The
purchasepriceofalldenominationsis50%ofthefacevalue.Theinterestratepaidisvariable.
Thehighertherateofinterestbeingpaid,theshortertheperiodoftimeittakesforthebondto
accruefromitsdiscountedpurchasepricetoitsfacevalue
(b) U.S.Treasurybillsareshortterm(lessthanoneyear)debtobligationsofthefederalgovernment.
Tbillsareexemptfromstateandlocalincometaxes,andfederaltaxesaredeferred.Theyare
regardedasthesafest,butgenerallylowestyieldingofallinvestments,and,thesecondary
marketforTbillsishighlyliquid.
(c) Certificatesofdeposits(CDs)aresavingsvehiclesinwhichfundsmustremainondepositfora
specifiedperiod.Prematurewithdrawalsincurinterestpenalties.Becauseoftherequirementthat
theyremainondeposit,CDsarelessliquidthanTbills,buttheyareconvenienttobuyandhold,
offerhighlycompetitivereturns,andhavefederalinsuranceprotection.
(d) Commercialpaperisunsecuredshorttermdebtissuedbycorporationswithveryhighcredit
standings.Thesecondarymarketforcommercialpaperisverylimitedandyieldsarecomparable
toyieldsonlargedenominationCDs.Typicallyonlylargerinstitutionsdealdirectlyinthis
marketbecausethedenominationsrangefrom$25,000tothemorecommonlyissued$100,000.
Commercialpaperisnotfederallyinsured.

Chapter1InvestmentEnvironment12

(e) Bankersacceptancesareshorttermcreditarrangementsbetweenbusinessfirmsandbanks.
Firmsusebankersacceptancestofinancetransactions,mostofteninvolvingfirmsinforeign
countriesorfirmswithunknowncreditcapacities.Bankersacceptancestypicallyare
denominatedin$100,000units,arelowrisksecurities,andhaveactivesecondarymarkets.
YieldsareslightlybelowCDyieldsandcommercialpaper,andaboveTbills.
(f) Moneymarketmutualfunds(MMMF)poolcapitalofmanyinvestorsandinvestitexclusivelyin
highyielding,shorttermsecurities,suchasTbills,largeCDs,commercialpaper,andother
similarsecurities.Becausethesehighyieldingsecuritiesareindenominationsof$10,000to
$1million,theMMMFmakesthemavailabletoindividualinvestors.MMMFsareconvenient,
offercheckwritingprivileges,andyieldsarebasedontheabilityofthefundmanagertoinvestin
variousshorttermsecurities.Althoughtheyarenotfederallyinsuredfunds,theirdefaultriskis
nearlyzerobecausethesecuritiestheyinvestinareverylowriskandthefundisrelatively
diversified.

Suggested Answers to Investing in Action Questions

Test Your Investment IQ (p. 4)
HowhighisyourInvestmentIQasmeasuredbythequiz?
Answer:
Theaveragescorewasonly37%,orwelllessthanhalf.Rememberthatthisisjustoneofmany
instrumentsthatcouldbeusedtomeasureInvestmentIQ.Forexample,anotherassessmenttoolwouldbe
essayorientedexplanationsofaspecifiedinvestmentsstrengthsandweaknesses.

Lessons For Investment Success (p.15)

(a) Whyisitimportanttostartinvestingnow?
Answer:
Oneshouldstartinvestingnowinordertotakeadvantageofcompounding.A$1,000amountinvestedfor
tenyearsat7.2percentwilldouble.Thesameamountinvestedatthesameratefortwentyyearswill
quadruple.Insteadofjustaddinganother$1000,youearnanextra$1000frominterestbeingearnedon
interest.
Furthermore,therewillneverbeanidealtimetoinvest.Terroristthreats,economicconcerns,and
alternativeusesforthemoneyarealwayswithus.Studieshaveshownitismoreimportanttoinvestthan
topicktherightsecurity.Moneynotinvestedislikelytobespentandnotprovidefuturebenefits.
(b) Whyisitagoodideatodiversify?
Answer:
Diversifyingallowsyoutospreadouttheriskthatauniquefirmorindustryeventwillhaveadevastating
impactonyourinvestment.Itisimportanttodiversifyacrosstypesofassetsandnations.

Suggested Answers to Discussion Questions

1.

(a) Sinceyoufallintothecategoryofayounginvestor,yourkeyinvestmentgoalsshouldbeto
purchaseahouseandsavefortheeducationofyourchildren.Appropriateinvestmentsshould
focusontheeducationofyourchildren.

13Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(b) Youshouldconsidertheeffectsoftaxeswheninvesting,especiallythetaxrelativetreatmentof
capitalgainsanddividends.Yourfocusshouldbeonmaximizingtheaftertaxreturnonyour
investments.
(c) Sinceyouhavearelativelylonginvestmenthorizon,itisappropriatetofocusonhigherrisk
investmentssuchascommonstocksinyourportfolio.

Chapter1InvestmentEnvironment14

2.

Shorttermvehiclesplayanimportantpartinyourinvestmentprogram.Mostimportantlytheywill
provideapoolofreservesthatcanbeusedforemergenciessuchasreplacingcars,appliancesand
clothingthatwearoutovertime.
Savingsor
Investment
Vehicle
(a) Passbook
savings
account
(b) NOWaccount

Minimum
Balance
None

Yield
0.5%to$4.0%,
dependingon
economy

MethodandEase
ofWithdrawing
Funds
Inpersonor
throughteller
machines;very
easy
Unlimitedcheck
writingprivileges

Nolegal
minimum,but
oftensetat
$500or$1,000
Nolegal
minimum,but
oftensetat
$2,500
Typically$5,000
to$20,000

Atornear
passbookrates

Yes,upto
$100,000per
deposit

Slightlyabove
passbookrates

Yes,upto
$100,000per
deposit

Limitedcheck
writingprivileges

Similarto
MMDAs

Limitedcheck
writingprivileges

(e) SeriesEE
savingsbond

Initialdepositis
50%offace
value

(f) U.S.Treasury
bill

$25
Tailoredto
investorneeds

(h) Moneymarket
mutualfund

Nolegal
minimum

No,butFederal
government
issue
No,butassecure
asmostbank
savingsand
checking
accounts
No,buthas
investedina
varietyof
government
andbankissues

Secondary
marketexists

(g) Certificateof
deposit

Abouttwo
percentabove
passbook
savings
account
Slightlyabove
passbookand
NOWaccounts
Slightlyabove
asset
management
account

Yes,upto
$100,000in
banks,varies
elsewhere
No,butFederal
government
issue

(c) Moneymarket
depositaccount
(MMDA)
(d) Asset
management
account

Slightlybelow
passbook
savings
account

Solutions to Problems
1.

Federal
Insurance
Yes,upto
$100,000per
deposit

(a) Goal
$250,000
$31,500at8%for15yrs.
100,000
Additionalrequirement
$150,000
$150, 000
150 $36.83
(b) Annualdeposit:
$1, 000
$5,524.50

Penaltyof
3monthsinterest
forearly
withdrawal

Penaltyforearly
withdrawal

Maytakeafew
daystoreceive
checkfromfund

15Gitman/JoehnkFundamentalsofInvesting,NinthEdition

2.

(a) TaxonAllensincomeof$130,000.Lookingatthejointtaxreturnrate,wefind
(10%$14,000)[15%($56,800$14,000][25%($114,65056,800]
[28%(130,000114,650)]
$1,400[15%$42,800][25%$57,850][28%15,350]
$1,400$6,420$14,462.50$4,298
$26,580.50
TaxonZellsincomeof$65,000.Lookingatthejointtaxreturnrate,wefind
($10%$14,000)[$15%($56,800$14,000)][25%($65,000$56,800)]
$1,400[15%$42,800][25%$8,200]
$1,400$6,420$2,050$9,870.
(b) AllanmakestwiceasmuchasZell.
RatioofAllenstotaltaxtoincomeis($26,580.50/130,000)20.45%
RatioofZellstotaltaxtoincomeis($9,870450/65,000)$15.18%
Hencehigherincomeearnerspayahigherproportionaloftheirincomeastax.

3.

(a)
(b)
(c)
(d)
(e)
(f)

$50,000.00/$50.001,000sharesofstock.
1,000shares$2.00$2,000.00peryearbeforetax.$2,000.000.85$1,700.00aftertax.
($1,700.0010)$50,000.00$67,000.00.
$50,000.000.05$2,500.00peryearbeforetax.$2,500.000.67$1,675.00aftertax.
($1,675.0010)$50,000.00$66,750.00.
Theyshouldpurchasethestock.Eventhoughtheannualinterestfromthebondsismorethanthe
dividendincomefromthestock,aftertaxesthePangswillhavemoremoneyfromthedividend
incomethanfromtheinterestincome.

4.
(a)
(b)
(c)
(d)

CashFlow
Interest
Dividends
LTCapGains
STCapGains

Amount
$1,000
$3,000
$2,000
$2,000

Rate
28%
15%
15%
28%

Tax
$280
$450
$300
$560

Chapter1InvestmentEnvironment16

Solutions to Case Problems

Case 1.1Investments or Golf?
Thiscaseillustratesthemanyfacetsoftheinvestmentprocess;itinvolvesmuchmorethancommonstock.
Theauthorsrecognizethevalueofphysicaleducationandemphasizetheimportanceofsports,buta
courseininvestmentsoffersthestudentalifetimeoffinancialbenefits.Thus,ourargumentsforselecting
theinvestmentscourseshouldnotbeinterpretedasanegativestatementonphysicaleducation,butrather
asapositivediscussionofthemeritsofinvestments.
(a) Theterminvestmentsreferstotheprocessofidentifying,evaluating,selecting,andmonitoring
theplacementoffundswithaviewofpreservingorincreasingvalueand/orearningapositive
return.Juddhassimplyidentifiedoneinvestmentvehicle(stock).Hewillnotknowhowto
evaluateothervehicles,selectinvestments,ormonitorthemwithoutacourseininvestments.In
additiontolookingathisowninvestments,acourseininvestingwillgiveJuddanewperspective
ontheroleofinvestmentsintheeconomy.Hewilllearnthatasaninvestor,heisactually
supplyingfundstogovernmentandbusinesswhichwillenablethecontinuedstrengthandgrowth
ofthegeneraleconomy.
(b) Clearly,Juddhasignoredshorttermsecurities,bonds,options,commoditiesandfinancial
futures,mutualfunds,realestate,tangibles,taxshelters,andlimitedpartnerships.Eachoneof
thesevehiclesoffersanotherriskrewardrelationshipthatmaymeetcertainuniqueinvestment
requirementsthatcannotbemetbycommonstockalone.
(c) Judddoesnothavetheknowledgeneededtocarryouttheinvestmentprocessdescribedin
question2.Knowingaboutcommonstocksisnotthesameasunderstandinginvestments.There
isnoreasonwhatsoevertoassumethatcommonstockisthebestinvestmentavailabletoJudd.
Besides,theinvestmentdecisionhastobecompatiblewithhisgoals.SinceJuddisjuststarting
hiscareer,inallprobabilityhewillnotwanttochooseriskyinvestments.Stocksarefarriskier
than,say,aninvestmentinCDs.
Thereareotherconsiderationstoo.DoesJuddhaveplansforthefuturewhenhewillneedthe
money?Ifso,isitashorttermoralongtermneed?Answerstothesequestionswillhelp
determinewhetherheshouldmakeshorttermorlongterminvestments.Insummary,togainan
understandingoftheinvestmentdecisionandmanagementprocess,Juddshouldpassupthegolf
courseinfavoroftheinvestmentscourse.

Case 1.2Preparing Carolyn Bowens Investment Plan

Thiscaseallowsstudentstoevaluateaproposedinvestmentplanaimedatachievingcertainretirement
goals.
(a) TheamountcurrentlyavailabletoCarolynincludes$60,000fromtheproceedsofthelifeinsurance
and$37,500fromhersavingsaccount,oratotalof$97,500.At6percentcompoundedannually,her
moneywillbeworth:
Ifsheretiresatage62(7yearinvestment):
$97,5001.504$146,640$112,500(house)$259,140
Ifsheretiresatage65(10yearinvestment):
$97,5001.791$174,622.50$127,500(house)$302,122.50
(ThefuturevalueinterestfactorscanbefoundinAppendixB,TableB.1.)
(b) ValueofCarolynsassetsat62valueofsavingsaccountvalueofhouse:

17Gitman/JoehnkFundamentalsofInvesting,NinthEdition

$146,640$112,500$259,140
Similarly,valueofassetsat65$174,622.50$127,500$302,122.50
Carolynsannualincomeatage62wouldbe$259,140/12.659$20,470.81
Carolynsannualincomeatage65wouldbe$302,122.50/11.118$27,174.17

Chapter1InvestmentEnvironment18

(c)
AnnualRetirementIncome
Age62Retirement
AnnualS.S.&Pension
FundBenefits
AnnuityIncome
TotalAnnualRetirementIncome

Age65Retirement

$16,308.00
20,470.81

$20,256.00
27,174.17

$36,778.81

$47,430.17

(d) Carolynneeds$45,000peryear(beforetaxes)ofretirementincome.Withoutconsideringthechange
inhertaxstatusuponretirement,shewillnotsatisfythisgoalifsheretiresatage62.Atage65she
meetsherrequirement.ThenatureoftaxlegislationandthereductioninCarolynstaxliabilityupon
retirementmaymakeretirementatage65viable.
(e) Carolynsplanisextremelyconservativeandlowrisk.Thereturnsfromtheplanareverysecureand
probablyassured.Carolyncanbeconfidentthattheaccumulatedworthofherinvestmentswillbe
availabletoheratretirement.Herplantoretireatage65meetsherretirementincomegoal.Carolyns
planofferslowriskandlowreturn..Throughonlyaslightincreaseinrisk,shemightimproveher
returnoninvestmentandhavemorecushiontoallowforinflationandunexpectedexpenditures.
Carolyncouldpurchasehighlyratedbond,CDs,andotherbluechipsecurityinvestments.Inthis
manner,herriskaversionwouldbesatisfied,andshewouldearnahigherreturnonherinvestments.
Thisshouldpermitmorelikelyachievementofherretirementincomeobjectives.Therefore,withvery
littleincreaseinrisk,Carolyncouldinvestherfundsinvehiclesthatwillincreasetheprobabilitythat
shewillmeetorsurpassherrequirementofanannualretirementincomeof$45,000.