This document defines key investment terms related to objectives, risks, asset classes, and strategies. It discusses basic investment goals, factors to consider when choosing investments, and types of risk like financial, market, interest rate, and purchasing power risk. It also outlines rates of return calculations, capital gains advantages, diversification methods, common stock valuation measures, and real estate investment concepts. Fixed income investments, options, futures, and bonds are also defined.

1. CPCU 556 Personal Financial Planning - Part 3 Investments & Investment
Planning Key Terms
Basic Investment Objective Definition: earn the maximum possible total,
after-tax rate of return on the funds available for
investment, consistent with the person’s
investment objectives and the investment
limitations or constraints under which he or she
must operate
Factors in Choice of Investment (10) 1 Security of principal and income, 2 Rate of return
(yield), 3 Marketability and liquidity, 4
Diversification, 5 Tax status, 6 Size of investment
unit or denominations, 7 Use as collateral for
loans, 8 Protection against creditor’s claims, 9
Callability, 10 Freedom from care
Financial Risk Risk issuers of investments may run into financial
difficulties. E.g. Bonds where issuer defaults on
interest payments/principal. Common stocks
where corporation will reduce or eliminate
dividend payments or go bankrupt
Market Risk Risk arising from price fluctuations for a whole
securities market, for an industrial group, or for an
individual security—regardless of the financial
ability of a particular issuer to pay promised
investment returns or stay solvent. E.g. investor
market timing, market expectations out of line
with reality
Interest Rate Risk (3) Price changes of existing investments because of
changes in the general level of interest rates in
capital markets--Inverse movement that causes
selling at a discount. Rate Shock Analysis (high
quality bonds) can help investor determine
possible fluctuation over life of bond
1 Interest Rate Risk to income from investments
(bonds & preferred stock)
2 Short-Maturity Risk for securities that mature in
low interest rate period.
Donna M. Kesot, CPCU April 1, 2012

2. CPCU 556 Personal Financial Planning - Part 3 Investments & Investment
Planning Key Terms
3 Redemption or Call Risk (preferred stock &
callable bonds). Issuers can pay them off before
maturity.
One protection for these 3 risks is to buy longer
term bonds or securities with full or partial call
protection and laddering diversification.
Purchasing Power Risk When prices rise, purchasing power decreases.
Some diversification includes inflation hedge
investments but investment goal is to obtain best
after-tax total investment return possible,
consistent with other objectives.
Currency Risk When investing in international securities, the
value of the foreign currency can fluctuate.
Rates of Return (include the 4 equations) Nominal Yield = annual interest or
dividends/investment’s par or face value
Current Yield = annual investment
income/investment’s current price or value
Yield to maturity for bond selling at a discount =
(annual coupon interest + (discount/number of
years to maturity))/((current market price of bond
+ par value)/2)
Yield to maturity for bond selling at a premium =
(Annual coupon interest –(premium/number of
years to maturity))/((current market price of
bond/par value)/2)
Capital Gains Advantages (5) 1 Capital gains are not taxed until realized
2 Estate/heirs will get a stepped-up income tax
basis in the property equal to value at time of
investor death
3 can periodically sell (at capital gains tax rate) a
portion of appreciated property to produce same
result as a stream of interste or dividend income,
selecting best investmenet assets for both
Donna M. Kesot, CPCU April 1, 2012

3. CPCU 556 Personal Financial Planning - Part 3 Investments & Investment
Planning Key Terms
investment and tax considerations
4 income tax is lower on capital gains than
ordinary income (top rate 18-20%)
5 Numerous planning techniques to avoid capital
gains tax, defer taxation, or stretch out a gain
Capital Gain Limitations (3) 1 inherently uncertain
2 capital gains lock-in problem for highly
appreciated assets
3 investing for capital gains places greater
emphasis on investment skills (using experience,
average annual compound rate of gain, rule of 72,
etc.)
Rule of 72 Average annual rate of gain = Average annual
compound rate of capital gain = (72/number of
years it takes an investment to double in value)
Average Annual Compound (geometric) Rate of The final value of asset or asset group includes
Total Return initial value and annual cash flows (dividends,
rents, etc.) during the period.
Unless the yearly total returns are exactly the
same, the geometric average annual rate of return
will be less than the arithmetic average annual
rate of return
After Tax Yield After tax yield = yield rate *(1 - tax bracket rate)
Taxable Equivalent Yield Taxable Equivalent Yield on tax exempt asset =
Asset yield/(1 - investor’s highest marginal income
tax rate).
After Tax Total Return Must consider whether capital gains (or losses) are
partly ordinary income and partly capital gains
3 methods of diversification Diversification = mixing types of investment media,
e.g. common stocks, bonds, CDs, money market
funds, preferred stocks/bonds, etc., life insurance
Donna M. Kesot, CPCU April 1, 2012

4. CPCU 556 Personal Financial Planning - Part 3 Investments & Investment
Planning Key Terms
and annuities, real estate, & other tax shelters
1. Investments made through financial institutions
that diversify their investments
2. Purchase one or more securities/units
periodically over a long period of time (dollar
averaging)
3. Investor follows own diversification strategy
Donna M. Kesot, CPCU April 1, 2012

5. CPCU 556 Personal Financial Planning - Part 3 Investments & Investment
Planning Key Terms
5 Measures of value for common stocks Earnings per Share
Price–Earnings Ratio
Net Asset Value (book value) per Share
Liquidated Value per Share
Yields
Dollar Cost Averaging The investment of a certain sum of money, at
regular intervals, in the same stock or stocks or the
same investment intermediary.
Margin Accounts Allows investors to put up some of their own
money and borrow the remainder. The (initial)
minimum down is set by the Fed.
Selling Short Selling securities that the investor either 1. does
not possess, and therefore must borrow to settle
the account; or 2. does possess, but does not wish
to deliver.
Taxpayer Relief Act (1997) generally eliminated
selling short-against-the box, except limited
circumstances.
SIPC Securities Investor Protection Corporation, an
outcome of 1970 Securities Investor Protection Act
to provide funds to protect customers of an SIPC
member firm if the firm becomes insolvent and is
liquidated (generally fully paid securities
“specifically identified” as belonging to the
investor.
Types of Stocks Growth Stocks, Income Stocks, Defensive Stocks,
Cyclical Stocks, Blue-Chip Stocks, Speculative
Stocks (is FB a speculative stock?), Small and
Midsize Company Stocks (small cap), Special
Situation Stocks (e.g. new processes, product,
resource, invention, etc.), Foreign Stocks
Defensive Stocks Stable and comparatively safe stocks such as
utilities and food whose utility is not eliminated by
Donna M. Kesot, CPCU April 1, 2012

6. CPCU 556 Personal Financial Planning - Part 3 Investments & Investment
Planning Key Terms
recession.
Name 4 theories of common stock investment 1. Growth Theory
2. Value Investing
3. Moderating Growing Industries & Income
Approach
4. Depressed-Industry Approach
Degree of Risk Degree of risk = dispersion of individual yearly
returns around the average return.
The larger the standard deviation, the greater the
volatility. Risk is determined by the standard
deviation of the arithmetic returns for the periods
indicated.
Alpha = measure of an investment’s return not
associated with overall market changes
Beta = price movement relative to overall market
index, e.g. is it trending with the market? The
higher the beta, the higher the volatility.
Bear Market A reasonably long period of time during which
common stocks in general consistently decline by a
significant amount (20% or more).
Donna M. Kesot, CPCU April 1, 2012

7. CPCU 556 Personal Financial Planning - Part 3 Investments & Investment
Planning Key Terms
Operating Rate of Return Operating Rate of Return = (net operating income
from property before interest and depreciation) /
(purchase price for property)
Net Operating Income Net Operating Income (NOI) = annual rent or
revenue – property tax and other expenses*
*other expenses do not include interest,
depreciation, and income tax
Disadvantages of real estate as an investment (4) Lack of marketability
Need for large initial investment
Real estate cycles and leverage
High risk level
Advantages of real estate as an investment (6) 1. Attractive Total ROE
2. Availability of Substantial Financial
Leverage
3. Favorable Cash Flow
4. Hedge Against Inflation
5. Tax Advantages
6. Control & Pride of Ownership
Real Estate Investment Trusts (REITs)
A corporation or trust that meets the legal
definition of the tax law for REITs primarily
investing in real estate.
Offers advantages of centralized mgmt., limited
liability, continuity of interests, and transferability
of ownership.
Real Estate Classifications (4) Unimproved land
Improved real estate held for rental*β
Mortgages
Vacation and second homes
*certified historic structures receive special tax
treatment
Β Includes new & used residential property, low
Donna M. Kesot, CPCU April 1, 2012

8. CPCU 556 Personal Financial Planning - Part 3 Investments & Investment
Planning Key Terms
income housing, old buildings and certified historic
structures, other income producing real estates
like office buildings, shopping centers,
warehouses, hotels/motels, industrial/commercial
properties.
Like-Kind Exchanges (AKA Section 1031) Tax deferred real estate exchanges of similar
property
no realized capital gain
income tax basis of property exchanged
carries over
may incude a boot
*boot = cash/personal property received in
addition to like-kind real estate
Passive Activity A tax favored treatment for:
1. a trade or business in which the taxpayer
does not materially participate on a
regular, continuous, and substantial basis;
or
2. an activity primarily involving the rental of
real estate whether the tax payer
materially participates or not
IPOs Initial public offerings
Par Maturity value
Oil & Gas Ventures IDC = intangible drilling costs
Up to 80%--90% of initial cost of a productive
well
Can be deducted against other income when
“working interest”
Depletion allowance is also deductible
Donna M. Kesot, CPCU April 1, 2012

9. CPCU 556 Personal Financial Planning - Part 3 Investments & Investment
Planning Key Terms
Put & Call Put = Trading in options to buy or sell common
stock
Should be for cash
Should be on stock or asset that the buy
wants in the portfolio
Call = option allowing purchase of stock or asset at
set price (the exercise or strike price)
Should be only on securities owned by the
seller (not naked call options)
Buying Options Speculative option for purchase of stock where a
premium is paid for the stock speculating that it
will fluctuate up or down
Futures Contract Agreement to buy/sell a commodity at a price
stated in the agreement on a specified future date
Fixed Income Investments Corporate Bonds
Municipal bonds
Marketable US government obligations
US Savings Bonds
US government agency securities
Zero-coupon bonds (corporate, muni, & US gov.)
Certificates of Deposit
Guaranteed investment Contracts (GICs)
Liquid assets (cash equivelents)
Preferred stock
Zero-coupon bonds Original Issue Discount Bonds (OID)
Bonds originally issued below par and which pay
no interest
Bonds Purchased at Premium Bonds purchased in the open market for more
Donna M. Kesot, CPCU April 1, 2012

10. CPCU 556 Personal Financial Planning - Part 3 Investments & Investment
Planning Key Terms
than par are bought for a premium. The bond
cannot be redeemed above par. This purchase is
for the income stream on interest
Donna M. Kesot, CPCU April 1, 2012