Investment Decisions
Investment Decisions
What is an Investment Decision?
Investment decision refers to financial resource allocation. Investors opt for the most suitable assets or investment opportunities based on risk profiles, investment objectives, and return expectations.
Investment Decisions, also known as Capital Investment Decisions are the most important financial decisions that an enterprise makes to utilize its funds to secure benefits over a period of time. It’s an integral component of the strategic decision-making of an enterprise or organization.
The term investment decision is interchangeably used with Capital Budgeting or Capital Expenditure Decisions. The decision greatly impacts the future course of the enterprise making the investment decision. Therefore, a series of prerequisite processes and diligent procedures such as Feasibility Study, Pre-FEED, FEED, and Cost Estimation is followed to reach an investment decision.
Once the investors and project owners reach a consensus over proceeding with the investment, it is known as the Final Investment Decision (FID). Hence, FID can be seen as the official start of a project when the real funds are utilized.
Process for Investment Decisions
1. Understanding the Client
2. Asset Allocation Decision
3. Portfolio Strategy Selection
4. Asset Selection Decision
5. Evaluating Portfolio Performance
Step 1- Understanding the Client
The first and the foremost step of investing process is to understand the client or the investor his/her needs, his risk taking capacity and his tax status. After getting an insight of the goals and restraints of the client, it is important to set a benchmark for the client’s portfolio management process which will help in evaluating the performance and check whether the client’s objectives are achieved.
Step 2- Asset Allocation Decision
This step involves decision on how to allocate the investment across different asset classes, i.e. fixed income securities, equity, real estate etc. It also involves decision of whether to invest in domestic assets or in foreign assets. The investor will make this decision after considering the macroeconomic conditions and overall market status.
Step 3- Portfolio Strategy Selection
Third step in the investment process is to select the proper strategy of portfolio creation. Choosing the right strategy for portfolio creation is very important as it forms the basis of selecting the assets that will be added in the portfolio management process. The strategy that conforms to the investment policies and investment objectives should be selected.
There are two types of portfolio strategy.
1. Active Management Process
Active portfolio management process refers to a strategy where the objective of investing is to outperform the market return compared to a specific benchmark by either buying securities that are undervalued or by short selling securities that are overvalued. In this strategy, risk and return both are high. This strategy is a proactive strategy it requires close attention by the investor or the fund manager.
2. Passive Management Process
Passive portfolio management process refers to the strategy where the purpose is to generate returns equal to that of the market. It is a reactive strategy as the fund manager or the investor reacts after the market has responded.
Step 4- Asset Selection Decision
The investor needs to select the assets to be placed in the portfolio management process in the fourth step. Within each asset class, there are different sub asset-classes. For example, in equity, which stocks should be chosen? Within the fixed income securities class, which bonds should be chosen?
Also, the investment objectives should conform to the investment policies because otherwise the main purpose of investment management process would become meaningless.
Step 5- Evaluating Portfolio Performance
This is the final step in the investment process which evaluates the portfolio management performance. This is an important investing process step as it measures the performance of the investment with respect to a benchmark, in both absolute and relative terms. The investor would determine whether his objectives are being achieved or not.
Types of Investment Decisions
Source: https://images.app.goo.gl/8DhfmoYZaYRpwjFg9
1. Short term investments
Short-term investments, also known as marketable securities or temporary investments, are financial investments that can easily be converted to cash, typically within five years. Many short-term investments are sold or converted to cash after a period of only three-12 months. Some common examples of short-term investments include CDs, money market accounts, high-yield savings accounts, government bonds, and Treasury bills. Usually, these investments are high-quality and highly liquid assets or investment vehicles.
Short-term investments can also refer to the holdings a company owns but intends to sell within a year.Common examples of short-term investments include CDs, money market accounts, high-yield savings accounts, government bonds, and Treasury bills.
Although short-term investments typically offer lower rates of return, they are highly liquid and give investors the flexibility to withdraw money quickly, if needed.Any increases or decreases in the value of a company's short-term investments are directly reflected on a company's income statement for the quarter.
2. Long term investment
A long-term investment is an account on the asset side of a company's balance sheet that represents the company's investments, including stocks, bonds, real estate, and cash. Long-term investments are assets that a company intends to hold for more than a year.
The long-term investment account differs largely from the short-term investment account in that short-term investments will most likely be sold, whereas the long-term investments will not be sold for years and, in some cases, may never be sold.
Being a long-term investor means that you are willing to accept a certain amount of risk in pursuit of potentially higher rewards and that you can afford to be patient for a longer period of time. It also suggests that you have enough capital available to afford to tie up a set amount for a long period of time.
Factors affecting Investment Decisions in Mutual Funds
1. Risk Factor
a) Interest Risk
b) Inflation Risk
c) Currency Risk
d) Volatility Risk
2. Liquidity Factors
3. Uniformity Factor
4. Quality of Returns Factor
5. Research Factor
1. The Risk Factor
Investments are always fraught with danger. For example, while Mutual Funds provide benefits such as value for money and diversification to investors, they also carry some risks. The best thing an investor can do to reduce Mutual Fund risks is to learn more about them and practice strategies for mitigating them.
In general, changes in currency and interest rates, regional or global economic instability, and economic and market conditions are some of the factors.
a. Interest Risk
Investors are plagued by interest risk, which appears as fluctuating interest value over the course of the investment horizon. The uncertainties surrounding the capital an investor is likely to access at the end of the investment horizon are largely to blame.
In other words, the cost of the debt instrument will change if the interest rate does. For instance, the price of bonds declines when interest rates do, which causes the value of bonds to decline as well.
b. Inflation Risk
The risk of losing one's purchasing power, primarily as a result of rising inflation, is the best way to describe risks lead by inflation. Investors are typically exposed to the effects of this risk when the rate of returns on investments falls short of the rate of rising inflation.
For example, if the rate of returns is 5% and the rate of inflation is 3%, investors will only receive a return of 2%.
c. Currency Risk
The risk in question is the worry that falling exchange rates will result in lower investment returns. To explain, it is presumed that when the value of funds denominated in foreign currencies rises, the value of foreign currencies will fall. As soon as it is converted into INR, the rate of return will be directly lowered.
d. Volatility Risk
Equity-based funds typically make investments in the stock of corporations that are listed on stock exchanges. The value of these funds depends on how well businesses perform, which is frequently impacted by the predominant microeconomic factors. These variables include shifting governmental directives, SEBI rules, the state of the economy, RBI policies, etc.
2. The Liquidity Factor
This is one of the most crucial factors influencing investment decisions. The ease with which an asset (such as equity shares, debentures, etc.) can be exchanged for money on the stock market is referred to as liquidity.
Liquidity risk thus represents the risks involved in such trades since the successful conversion of stock into money depends on a number of factors, including a company's book value, the bid-ask spreads for its shares on the market, etc.
High liquidity risk typically means that particular security is difficult to buy or sell on the stock market. This is due to the possibility that an issuing company's current liabilities may prove difficult to satisfy as a result of decreased cash flow.
3. Uniformity Factor
A good Mutual Fund is one that consistently outperforms its benchmark over the long term, as every investor is aware. The excess return is referred to as the fund's "alpha" when it exceeds the benchmark.
Most importantly, it's your hard-earned money you're investing in a mutual fund with. The fund should surpass its benchmark and generate a higher alpha, as you should anticipate. It may be the first parameter you use.
Furthermore, fund performance is important. It should be taken into account for a suitable amount of time. This is done to make sure the investments have experienced several market cycles.
This would make it possible to get a steady return over time. This is one of the most important factors that any investor takes into account while making an investment decision.
4. Quality of Returns Factor
When investing in a high-return Mutual Fund, one of the first things a retail investor considers is that the return should be both high and steady.
Thus, you should avoid Mutual Funds that have recently offered very high returns but have otherwise not offered great returns as the quality and consistency of returns of a fund are some of the factors favoring investment decisions.
5. Research Factor
This might seem like a no-brainer, but you'd be surprised at how many people invest in the wrong fund only to discover later that it doesn't meet their needs. So, please, do not commit this error. A good investor will always place a high priority on their research.
Make sure it is a mutual fund you want to invest in before you start. Don't get sucked in because you overheard your friends talking about them, even though they are a fantastic option for most people.
Conclusion
Investment decisions are never easy. Cash flows, whether they are positive or negative, are fraught with uncertainty. Selecting the appropriate discount rate is never easy, but it has a dramatic influence on the go/no-go decision. Technical analysis using discounted cash flow techniques does not alleviate the uncertainty and does not permit hunches and intuition. One student noted that his presentation in another class was marked down because he had a hunch that a company should invest in a project, even though the NPV analysis was unfavorable. After discussing the issue for a short time, I let him in on the great secret that was revealed to me by one of my mentors after I had spent days trying to justify a modest expenditure using return on investment calculations. He told me to tinker with the numbers until they fit the desired outcome. Investment in emerging technologies and a new product line rarely result in positive NPVs unless the data have been cooked. Real options when combined with the development of a product and project portfolio can bring truth, beauty, and enlightenment into the investment process.
References
1. https://www.wallstreetmojo.com/investment-decision/#h-what-is-investment-decision
2. https://en.m.wikipedia.org/wiki/Investment_decisions
3. https://www.investopedia.com/terms/s/shorterminvestments.asp
4.https://saylordotorg.github.io/text_developing-new-products-and-services/s17-08-conclusion.html
5. https://www.investmentpedia.org/steps-of-investment-process/
6. https://groww.in/blog/factors-affecting-mutual-funds-investment-decisions
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