Investment decisions and organizing the activities in the decision process

1. Executive Summary

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This paper gives an overview of an investment advice that involves analyzing the basic nature of investment decisions and organizing the activities in the decision process. This requires an understanding of the various investment vehicles, the way these investment vehicles are valued and the various strategies that can be used to select the investment vehicles that should be included in a portfolio in order to accomplish investment objectives.

The decision-making process involves setting investment objectives of investors – the trade-off between expected return and risk, by determining the proportion of investor’s investible wealth and knowing their risk preferences; traditionally, the performing of security analysis involves the examination of the types of investment risks, the measures of risk and return using the appropriate asset pricing models on a number of securities and portfolio construction that involves the construction of optimal portfolios by identifying the asset class in which to invest as well as determining the proportions of the investor’s wealth to put in each asset and the investment strategies to minimize risk and maximize expected returns in the identified portfolios. The essay concludes with the practical implications of asset pricing theory and some concluding remarks on a good investment advice.

2 The Basis of Investment Decisions

Nearly all investors, whether institutional or individuals, seek to increase the future value of their assets or maximize their utility because a higher fund value gives them the ability to consume more. Investors wish to earn a return on their money. Cash has an opportunity cost: by holding cash, you forego the opportunity to earn a return on that cash. Furthermore, in an inflationary environment, the purchasing power of cash diminishes with high rates of inflation, bringing a rapid decline in purchasing power. In investments it is critical to distinguish between an expected return and a realized return. Investors invest for the future but when the investing period is over, they are left with their realized returns. What investors actually earn from their holdings may turn out to be more or less than what they expected to earn when they initiated the investment. The essence of the investment process: investors must always consider the risk involved in investing.

Investors would like high expected returns; however, their objective is subject to constraints, primarily risk though other constraints such as taxes, transaction costs and legal are facing all investors in the investment decision. The investment decision, therefore, must always be considered in terms of both risk and return. There are different types of risk. Risk is defined as the chance that the actual return on an investment will be different from its expected return. It is easy to say that investors dislike risk but more precisely, we should say that investors are risk-averse. A risk-averse investor is someone 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. In fact, investors cannot reasonably expect to earn higher returns without assuming higher risks. Investors deal with risk by choosing (implicitly or explicitly) 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. Other investors are unwilling to assume much risk and they are not rewarded with high returns.

Within the realm of financial assets, investors can achieve any position on an expected return-risk trade-off. Investors unwilling to assume risk must be satisfied with the risk-free rate of return but if they wish to try to earn a higher rate of return, they must be willing to assume a higher risk. Since returns are somewhat predictable, investors can enhance their average returns by moving their assets around among broad categories of investments.

The world of investment opportunities have changed: the future is uncertain, and the best that investors can do is to make probabilistic estimates of likely return over some holding period using the best and available information and the investment strategies available.

3. Security Analysis

Traditionally, investors can choose from a wide range of securities in their attempt to maximize the expected returns from these opportunities though they face constraints, however, the most pervasive of which is risk. Risk is inherent in different asset classes regardless of the securities in an asset class and across asset classes. Risk can be managed by changing the asset allocation of the portfolio. For most investors, the asset allocation they choose will be determined largely by their risk tolerance as all investors prefer higher expected portfolio returns to lower but these come with certain level of risks. Measuring investor’s risk tolerance is difficult, however, we can analyze the risk inherent in portfolio by using asset pricing theory to help investors to make informed decisions.

The initial investment decision-making process involves the valuation and analysis of individual securities. It is necessary to understand the characteristics of the various securities and the factors that affect them and a valuation model is applied to these securities to estimate their price or value. Value is a function of the expected future returns on a security and the risk attached. Both of these parameters must be estimated and then brought together in a model.

It is important to consider the time horizon and the risk of its payments in the valuation of a security. The effects of time are not too difficult to work out; however, corrections of risk are much more important determinants of many securities’ values.1 The prices of many assets are not easily observed such as potential public or private investment projects, new financial securities, buyout prospects and complex derivatives. We can apply the asset pricing theory to establish what are the prices of these assets.

Asset pricing theory stems from one simple concept: price equals expected discounted payoff.2 There are two approaches in pricing of assets: absolute pricing and relative pricing. In absolute pricing, we price each asset by reference to its exposure to fundamental sources of macroeconomic risk. The absolute approach is commonly used in which we use asset pricing theory positively to give an economic explanation for why prices are what they are, or in order to predict how prices might change if policy or economic structure changed.

In relative pricing, we can learn about an asset’s value given the prices of some other assets. We do not ask where the prices of the other assets are derived and use as little information about fundamental risk factors as possible. In choosing how much absolute and relative pricing one will do, it depends on the assets in question and the purpose of the calculation. For example, the CAPM and its successor factor models are paradigms of the absolute approach but in application, they price assets “relative” to the market or other risk factors, without answering what determines the market or factor risk premia and betas.

The CAPM is a good measure of risk and helps to explain the fact that some securities such as stocks, portfolios, strategies or equities, earn higher average returns than others. The CAPM states that assets can only earn a high average return if they have a high “beta”, which measures the tendency of the individual asset to move up or down with the market as a whole. Beta drives average returns because beta measures how much adding a bit of the asset to a diversified portfolio increases the volatility of the portfolio. When we analyze investment returns and risks, we are concerned with the total portfolio held by an investor. Individual security returns and risks are important but it is the return and risk to the investor’s total portfolio that ultimately matters because investment opportunities can be enhanced by packaging them together to form portfolios. A security may have large risk if it is held by itself but much less risk when held in a portfolio of securities. As investors are concerned primarily with the risk to his or her wealth, as represented by his or her portfolio, individual securities are risky only to the extent that they add risk to the total portfolio.

There are securities whose average returns cannot be explained by their beta; however, the CAPM multifactor extensions dominate the description, performance attribution and explanation of average returns by associating high average returns with a tendency to move with other risk factors in addition to movements in the market as a whole. This model provides particularly useful insights into analyzing the risk-return characteristics of a portfolio because it allows one to categorize the sources of risk and return into individual and identifiable components. The risk and return of a portfolio can be measured by combining these components and aggregate across individual securities to generate a set of efficient portfolios.

Generally, returns on securities are predictable, in particular to certain variables including the dividend/price ratio and term premium, which can predict substantial amounts of stock return variation. This occurs over business cycle and longer horizons but not daily, weekly and monthly stock returns as it is unpredictable. Bond returns are predictable. The expectation model works well in the long run: though a steeply upward slope yield curve means that expected returns on long-term bonds are higher than on short-term bonds for the next year, these predictions are not guaranteed as there is still substantial risk.

The view that risky asset returns are largely unpredictable or that prices follow “random walks” mean that if stock prices went up, there is no tendency for them to decline today or to continue to rise today because of trend. Any strategy to exploit the price movements for investors’ portfolios for forecasting short-term gains and losses will not do anything over the long run except to rack up their trading costs. The average returns on the market and individual securities do vary over time and that stock returns are predictable at long horizons associating with business cycles and financial distress.3

The task of asset pricing is to understand and measure the sources of aggregate or macroeconomic risk that drive asset prices or returns. For examples, expected returns vary across time and across assets in ways that are linked to macroeconomic variables or variables that also forecast macroeconomic events. Most importantly, risk corrections to asset prices should be driven by the co-movement of asset payoffs with marginal utility and hence by the co-movements of asset payoffs with consumption. Other things equal, an asset that does badly in states of nature like a recession, in which the investor feels poor and is consuming little, is less desirable than an asset that does badly in states of nature like a boom in which the investor feels wealthy and is consuming a great deal. The former asset will sell for a lower price; its price will reflect a discount for its “riskiness” and this riskiness depends on a co-movement, not the risk. Most of the theory of asset pricing is about how to go from marginal utility to observable indicators. Consumption is low when marginal utility is high, so consumption may be a useful indicator.

Investors must decide how much to save and how much to consume and what portfolio of securities to hold to maximize the expected returns at a given risk. Many investors are unaware they have a choice between active and passive management strategies. Every investor is different and they will choose a strategy that can maximize their expected returns or utility functions. A passive strategy seeks profits solely from bearing investment risk while an active strategy attempts to profit from identifying mispriced securities. Both strategies are speculative and speculative strategies involved timing or selection of appropriate securities.

All investors must determine a portfolio asset allocation that provides them with the best mix of risk and return. Passive investors make this decision in the belief that the expected returns on different asset classes are fair given the risk of each asset class while active investors will attempt to identify periods when, say, stocks are overvalued or undervalued relative to other asset classes. When they believe an asset class is overvalued, they underweight or hold less than they would normally do in the asset class in their portfolios or when they believe an asset is undervalued, they overweight the asset class.

The decision to pursue an active or passive strategy depends largely on market efficiency. Securities that are actively traded in major financial markets are most likely efficiently priced and other securities such as those traded in emerging markets might not be properly priced and require an active management approach. The decision to use an active versus a passive approach to manage an investment portfolio depends on the types of securities to be owned and the investor’s knowledge.