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.

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1.        Executive Summary

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.

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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 ...

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