The most critical challenge faced by investors is investment decisions. Decision-making is defined as the process of choosing a particular alternative from a number of alternatives, Sevilla (1972). Knowing where to invest, how much money to put in as the proper timing are key ingredients in making sound and wise investment decisions. According to Miranda (2002), one of the most important finance functions is to intelligently allocate capital to long-term assets which is called capital budgeting. In order to get the maximum yield in the future, someone must allocate his capital into long-term assets. It is difficult to calculate future return because of future uncertainty. Along with this uncertainty comes the risk factors which to be taken into consideration. The key to a successful financial plan is to keep apart a larger amount of savings and invest it intelligently, by using a longer period of time. The turnover rate in investments should exceed the inflation rate and cover taxes as well as allow you to earn an amount that compensates the risks taken.
Savings accounts, money at low interest rates and market accounts do not contribute significantly to future rate accumulation. While the highest rate come from stocks, bonds and other types of investments in assets such as real estate. Nevertheless, these investments are not totally safe from risks, so one should try to understand what kind of risks are related to them before taking action. The lack of understanding as how stocks work makes the myopic point of view of investing in the stock market ( buying when the tendency to increase or selling when it tends to decrease) perpetuate. Risk is an inherent part of investing. The risk factor plays a very significant role in calculating the expected return of prospective investment.
Furthermore, inflation has served to increased awareness of the importance of financial planning and wise investing. More inflation is a worry for each and every individual. Due to inflation value of your money in future will decrease. To Cope up this, investors wants to invest their money and earn certain rate of return which is more than rate of Inflation. Having clear reasons or purposes for investing is critical to investing successfully. Review of Related Literature When talking about investment, it is not necessarily a matter of continuously accumulating wealth or being materialistic. Rather, it should be located upon as a means of reducing future financial worries and ultimately in providing financial and personal independence.
In his book, Business Finance, Second Edition (2007), Medina defined that investment is made when a firm spends, some of its funds for the establishment of a project. By doing so the opportunity to use the same funds in the possible project is loss. Investment refers to assets acquired to realize income and/or earn profit. They are expected to increase one‟s equity or reduce future financial worries. It requires sacrificing some of current pleasures with the hope and expectation that resources acquired will enhance the future (Mejorada, 2001, p. 3). Investment is held to refer to the employment of funds in the productive assets for the process of acquiring profits. A businessman is said to engage in investment when he places additional funds in his business enterprise so that he can look forward to the receipts of increased profits, just as when he engages in the purchase of securities managed by others. Investment shall be held to the placement of capital to be managed by others in order to obtain adequate rewards therefrom in the form of interest, dividends, changes, rents or capital (Miranda, 2002).
Investing and Speculation One of the factors that can make it difficult to know the difference between investing and speculating is that both produces gains and losses. Some sound investment strategies can turn losses for a fewer years, while speculating rakes in high returns just long enough to earn some credibility. In his book, Elements of Business Finance (2002), Miranda differentiate investment from speculation as, investment involves the deliberate assumption of substantial risks for the purpose of securing capital appreciation or a high rate of return. While speculation refers to the buying and selling at another time to take advantage of price changes that have occurred during the interval. The main difference between speculating and investing is the amount of risk undertaken in the trade. Typically, high-risk trade that are almost similar to gambling fall under the umbrella of speculation, whereas low-risk investments based on fundamentals and analysis fall into the category of investing.
Investment Portfolio Warren et al. (1990) and Rajarajan (2000) predict individual investment choices (e.g., stocks, bonds, real estate) based on lifestyle and demographic attributes. These investors see rewards as contingent upon their own behavior (Rajarajan, 2002). Gupta (1991) argues that designing a portfolio for a client is much more than merely picking up securities for investment. The portfolio manager needs to understand the psyche of his client while designing his portfolio. Risk tolerant investors behave as though they can control risk. This suggests that risk tolerance serves as a proxy for an „illusion of control‟ and thus overconfidence [Madhusoodanan (1997); Odean (1998); Barber and Odean (2001); Benartzi and Thaler (2001); Gervais and Odean (2001); and Daniel and Huberman (2003)]. Investment portfolio is a pool of different investments by which an investor bets to make a profit while aiming to preserve the invested amount (Business Dictionary, 2012). Portfolio refers to the briefcase that is used in carrying business papers and documents.
In business, it refers to the aggregate of assets held as investment (Mejorada, 2002). Investment portfolio contains bank accounts, treasury bills, bonds, commercial papers, precious metals and stones, and real estate. Portfolio manager is the person or office given the authority to make decisions regarding investments of an individual or entity. Its function is to give financial advice to help the corporation determine how much money to it needs to meet the legal requirements for the issuance; there should be teamwork between the investment banker and the issuer. Investment Decision-Making Effective organizational decision-making is the primary responsibility and the reason for the existence of management (Dearlove, 1998). According to Drucker (1979): “Executives do many things in addition to making decisions. But only executives make decisions. The first managerial skill is, therefore, the making of executive decisions.”(Drucker, 1979, p. 2)
Furthermore, of all decisions that business executives must make, none is more challenging than choosing among alternative capital investment opportunities (Hertz, 1964). Here executives must decide to invest some fixed amount today in exchange for an uncertain stream of certain pay-offs. For example, manufacturing executives invest in new facilities and equipment hoping to streamline their future manufacturing operations and reduce production costs. Yet setting into the unknown, which is essentially what investment decision-making is, means that mistakes will surely occur. Each investment decision often involves complexity and uncertainty. Complexity is reflected, in part, by the number of alternative courses of action from which the decision maker can choose. Uncertainty is inherent in all decision-making but particularly pertinent to the investment decision-maker where the implications of their decisions are often very significant for the organization. Moreover, executives are usually trying to fulfil multiple objectives in their investment decision and therefor have to make trade-offs between expected returns and riskiness.
Perhaps it is not surprising given this that entrepreneurs, on average, have nine failures for each major success. Forms of Investment Investment, as the dictionary defines it, is something that is purchase with money that is expected to produced income or profit. Investments can be broken into three basic groups: ownership, lending, and cash equivalent. Ownership investments are what come to mind for most people when the word “investment” is batted around. This is the most volatile and profitable class of investment. Ownership investment could either be stocks, literally the certificates that say you own a portion of a company; real estate, these are houses, apartments or other dwellings that you buy to rent out or repair and resell; and precious objects, these are objects that are brought with the intension of reselling them for a profit. Lending investment allows you to be the bank. They lend to be lower risk than ownership investments and return less as a result. It could be in the form of savings account or bonds. Cash equivalents are investments that are “as good as cash”, which means they are easy to convert back into cash. Money market fund is the best example of this. Risks and Risks Tolerance According to Medina (2007), uncertainty as to loss is called risk.
In business world, it is the potential incurrence of loss of money or its equivalent. It refers to the degree of risk that an investor can be comfortable with or his appetite for risk. The greater is the risk, the greater must be the gain. “Since risk is essentially a mathematical construct, not an emotional one, the ability to properly understand and assess risk is critical” (Pablo, 1997) The role of risk and uncertainty in decision-making is a topic that has increasingly attracted the attention of both practitioners and scholars. However, as indicated, managers hold widely divergent views on the handling of risk and uncertainty in business situations, with some taking a more analytical approach, whereas others appears to operate on a more intuitive basis. Similarly, researchers have historically developed explanations of how decisions are made under risk and uncertainty from a variety of theoretical perspectives, resulting in a fragmented and often contradictory body of literature on the subject (Pablo, 1997).
The common types of risks are those which involved safety of capital and safety of income. In investment market, the quality of an investment is evidenced by the yield or returned that is produced in relation to market price – the higher the quality, the lower the yield (Miranda, 2002). The amount and the stability of the earning power of the issuer are the dependants of principal. Thus, as compared to stocks, there is greater safety of principal in the case of bonds. The reason behind is that bonds enjoy a priority of stocks, which represents share of ownership. As to safety of income, the value of high-grade, meaning marketable securities rises and falls moderately as interests and dividends rate fall and rise (Miranda, 2002). Income risk is caused by a variety of factors. Typically, common (aggregate, economy-wide, and covariate) risk is distinguished from individual (idiosyncratic) risk: the former affects everybody in a particular community or region; the latter only affects a particular individual in the community.
Perhaps the most important question an individual needs to ask when constructing an investment portfolio is: “what is my risk tolerance?” The combination of return objectives and risk tolerance will then determine the optimal portfolio and the optimal asset allocation. Again, time horizon plays an important role in determining risk tolerance. The longer the time horizon, the more risk an investor is able to take. The shorter the time horizon, the more cautious an individual should be in his or her investment approach (Harper, 2012). The above discussion focuses on the ability to take risk, but there is another important consideration in determining risk tolerance. In addition to ability to take risk, investors should also carefully consider their willingness to take risk. These two factors are not always in alignment. For instance, an investor with a long-term goal may have the ability to take on additional portfolio risk, but if the thought of losing money keeps them awake at night they might not have the willingness to take much risk.
Investors should attempt to align their ability and their willingness to take risk. However, in situations where ability and willingness provide conflicting signals, investors should defer to that which is more conservative. In other words, if an investor has the ability to take risk but not the willingness, they should take less risk. On the other hand, even if an investor is aggressive by nature, if their objectives are short-term in nature, they should probably invest conservatively. Diversifications over Investment Decisions According to Mejorada (2001), diversification as applied to investment refers to spreading investable funds to investment items. When investing it should be a mix of different assets, not just in the form of cash.
This is observed in order to benefit from the advantages that each of them brings about, to avoid putting one‟s money in “one basket” – and consequently minimize risk from over-exposure to only one land of asset. It may also include investment among the different assets under one category. The extreme spreading of the investable funds to so many items of investment is socalled over-diversification. It brings forth the inability of investor to keep track of developments in each item of investment, increased transaction costs and minimized earnings from more profitable items of investment (Mejorada, 2001). The advantages of a policy of diversification of investments are: risks are spread out through holding securities in a cross-section of industries and companies; risks reduction thru advice from professional experts who through research and continuous study, adjust investment funds to changes in market and business conditions, in case the investor engages the consultation services of such experts (Miranda, 2002, p. 303). Conclusion and Recommendation This term paper has highlighted that decision should not be perceived to be providing a dictatorial straitjacket of rationality (French, 1989). Rather it should be seen to be a delicate, interactive, exploratory tool which seeks to introduce intuitive judgements and feelings directly into the formal analysis of a decision problem (Raiffa, 1968).
A scientific understanding of how firms make investment decision and for the optimal design of compensation contracts and capital budgeting procedures to motivate profitable investment is a crucial analysis of managerial understanding. The effect of it on investment depends on the following factors: how soon investors can observe the profitability of project undertaken, whether investment policy is visible to outsiders, and how tolerant the manager is of risk. The researcher concludes by summarizing the major consequences for investment choices of managers‟ desire to build and maintain reputation.
1. If the investment policy is visible to the market, the greater investment tends to be favorable indicator of managerial and firm quality, implying that firms will tend to reinvest. Furthermore, a manager must be concerned not just with how his project will be viewed, but how this compares with investors‟ current assessments. 2. If a manager owns an asset from which he can generate more cash flows today than the market expects, then he has an incentive to convert the asset into cash early even if the value would be maximized by holding on to the asset and “harvesting” it later. However, if the manager has imperfect control over when the project outcome will be resolved, the manager may also defer cash flows in order to conceal a likely failure.