Investment and Portfolio Management
Investment Decision Process:
The investment process involves analyzing the basic nature of investment decision and
organizing the activities in the decision process. Common stocks are producing higher return as
compare to bonds and savings accounts, but they are assumed to be very risky. So in investment
decisions there is a trade off between risk and expected return. Before going for investment
decision process, first we explain risk and return.
Return:
Return is the financial term for the profit or loss derived from an investment. The investors wish
to earn a return on their money. Cash has an opportunity cost, by holding cash, you forego the
opportunity to earn on that cash. Furthermore, the purchasing power of cash diminishes, with
high rate of inflation. In investment the return is classified into two types, an expected return and
realized return. Expected return is the anticipated return for some future period, whereas realized
return is the actual return over some past period. Investors invest for the future (expected return),
but when the investing period is over, they are left with their realized return. The actual return
can be high or low than the expected return at the time of investment. This shows that there is an
element of risk in investing.
Risk:
Risk exists when the decision maker knows not only the various future outcomes, but also the
probabilities associated with each potential outcome. Risk is quantifiable uncertainty. Risk can
be defined as the possibility that the actual return will deviate from the expected return. Risk can
be understood with reference to the uncertainty of future cash flows produced by assets (Physical
& Financial Securities). The actual cash flows one or five years from now may be very different
from the forecasted and this to represent risk. Investors dislike risks they are usually risk averse.
A risk-averse investor is one who will not assume risk simply for its own sake and will not incur
any given level of risk unless there is an expectation of adequate compensation for having done
so. Investors deal with risk by choosing the amount of risk they are willing to incur. Some
investors choose to incur high levels of risk with the expectation of high levels of return.
Risk and Return trade off:
The line RF shows the risk free return on investment such as T-bills. This position has zero risk
level. As investor moves from risk-free to more risky assets such as bonds and common stock,
he/she assumes more risk in the expectation of earning a large return.
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Investment and Portfolio Management
Futures
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r RF Bond
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Risk
Decision Process:
An investor’s portfolio is simply his collection of investment assets. Wealth is evaluated and
managed within the context of a portfolio, which consists of the assets holding of an investor.
Once the portfolio is established, it is updated by selling existing securities and using the
proceeds to buy new securities, by investing additional funds to increase the overall size of the
portfolio, or by selling securities to decrease the size of the portfolio. Investors can choose from
a wide range of securities in their attempt to maximize the expected returns from these
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Investment and Portfolio Management
opportunities. Investors make two types of decisions in constructing their portfolio: security
analysis and portfolio management.
1) Security analysis:
The first part of the investment decision process involves the valuation and analysis of individual
securities, which is referred to as security analysis. An investor who has all his money in saving
account would first decide what proportion of the overall portfolio ought to be moved into
stocks, bonds, and so on. In this way, the broad features of the portfolio are established. First of
all it is necessary to understand the characteristics of the various securities and factors that affect
them. Second, a valuation model is applied to these securities to estimate their price, or value.
Value is a function of the expected return on a security and the risk attached. Steps in security
analysis:
1) The analyst considers prospects for the economy, given the state of the business cycle
2) The analyst determines which industries are likely to fare well in the forecasted economic
conditions
3) The analyst chooses particular companies within the favored industries
2) Portfolio management:
The second major component of the decision process is portfolio management. After securities
have been evaluated, a portfolio should be selected. Portfolio management is concerned with the
management of a group of assets as a unit. Having built a portfolio, the investor must consider
how and when to revise it. A properly constructed portfolio achieves a given level of expected
return with the least possible risk. Portfolio is managed regardless of whether the investor is
passive or active.
Passive investment strategy involves determining the desired investment proportions and assets
in a portfolio and maintaining these proportions and assets, making few changes. Active
investment strategy involves specific decisions to change the investment proportions and assets,
based on the belief that an investor can profit by doing so.
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Investment and Portfolio Management
The activeness and passiveness of the investor depends upon efficient market hypothesis (EMH).
EMH is the proposition that security markets are efficient, with the price of securities reflecting
their economic value. Under this hypothesis security prices fully reflects all the available
information. Strong believers in EMH may adopt passive investment strategy, because of the
likelihood that they will not be able to find underpriced securities. On the other hand, investors
who do not accept the EMH, pursue active investment strategy, believing that they can indentify
undervalued securities and that lags exist in the market’s adjustment of these securities’ prices to
new information.
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