Portfolio Theory
Name
Institution
How does the separation outcome change when making the optimal investment decision under certainty when compared to making the optimal investment decision under uncertainty? You may assume a risk-free asset exists where relevant.
We shall exam uncertainty when making optimal investment decisions in which the objects of uncertainty are stated in terms of the statistical parameters as well as the probability distribution of the financial claims. The decision-making under uncertainty involves the market uncertainty as well as the event uncertainty. Market uncertainty refers to when investors have difficulty in assessing the current and future market condition because of volatility in the market place (Quinlan, 2022).The event uncertainty refers to the unpredictability of future events that may influences the decisions to be made.
For this study we shall use XYZ PLC which is a hypothetical investments company.
XYZ PLC also has identified the importance of timely making of the right investment decisions which leads to company’s future growth and enhance the shareholder wealth and they follow a 5 step process to make investment decisions.
1. Understanding of company goals and objectives periodically:
Understanding of company’s goals and objectives and aligning capital investments with pre-set goals and objectives is important when making investment decisions. As the first step, XYZ PLC comply with their investment opportunities with their company goals and objectives where decided on annual budget in the company to set a benchmark for the company’s portfolio management process.
02. Decision on assets allocation:
As the second step, they make decision on asset allocation. At this stage, they usually decide the area where they are going to invest their capital. For an example, at the second stage of the investment decision making process they determine whether they are investing in real estate, invest in equity, Invest in fixed deposits …etc. When deciding on asset allocation, they generally consider and study macroeconomic factors such as interest rates, inflation, industry growth rate etc. to minimize the investment risk. And also they consider and analyze the cash flows of each investment and time taken to recover the investment.
Generally we consider and study on macroeconomic factors in order to make a decision on assets allocation.
03. Ranking of portfolio:
At this stage, they conclude the investment value and opportunities based on return on investment in each opportunity or asset. For an instance, they like to invest more in the investment opportunities where the company can end up with higher returns and they give a high rank for those kind of investments and they assign lower ranks for investments which gives lower Return on Investment Further, at this stage, their investment team execute a financial feasibility test for each opportunity or asset before ranking of the same and will pass to the investment committee of the company for final review and approval before presenting it to the board of the company.
04. Decision on opportunities or asset selection:
At this fourth stage of the process, they would further consider sub-opportunities or sub assets of each opportunity to be placed in the portfolio management and they carry out a detailed analysis. For an example if they are going to invest in equity, they have to select either ordinary shares or preference shares to be placed based on the Return on Investment. After considering sub opportunities and rank assigned based on Return on Investment value, they make decisions on which opportunities or projects they are going to capitalize.
05. Evaluating of the portfolio performance (variance analysis of the actual Vs forecasted)
This is the final step of the process of investment decision making practice in XYZ PLC. Evaluating the actual asset performance with the expected performance and take corrective actions immediately to get the project back to the track if there are any deviations is very important as capital investments are long term and critical for the future growth and success of any company. Hence, at this final stage of investment decision making process, XYZ PLC analyzes the actual performance of each invested opportunity they execute and compare it with the expected performance to identify whether there are any deviations in order to determine that the invested project is generating expected outcomes and company objectives are achieved or not.
The second first of information is the information on the industry on which the investment opportunity being analyzed operates under. This will include government policies affecting that specific sector; the level and nature of competition in the market and other uncontrolled factors such as the extent of effects of weather patterns on the operations of the company. Generally, this piece of information entails everything on the environment under which the company operates on. The last piece of information to be obtained is information relating to the company itself. This includes the governing policies of the company, the level of experience that both the management and employees of the company possess and the market control strategies employed by the organization in their operations. How that company deals with crises both in operation and management is also important for the fundamental analysis by the investors.
Some of the events that should be taken into consideration when making optimal investment decisions are such as the current oil price shocks which have driven up the cost of doing business especially in manufaturing.This would mean stocks of manufacturing companies would be less appealing to investors given such event uncertainties.
Investment decisions are also based on the risk return portfolio because of the higher the risk the higher the returns for the investor.However,the investor must balance between his risk appetite and the returns as there are those who are risk averse, risk neutral or risk lovers. The likelihood that an actual return deviates from the expected return is what is referred to as the risk. Some of the sources of risk for the XYZ hypothetical company would be such as the risk of default, interest rate risk, purchasing power risk, market risk, reinvestment risk and call risk.
Laws and regulations about investing decisions
In most countries, laws, and regulations governing business practices require that those companies which have been listed by trade bureaus to openly display their financial reports of operations over a specified period annually, bi-annually or even quarterly (Ogbonna & Ebimobowei, 2011). This is in the realization of the importance of accurate economic and financial in making decisions on investment opportunities. Before deciding on where and how to invest, investors need to know the projected financial performance of the company. This helps them to determine the feasibility of their investment and the chances of their projected return on investments being met. According to major investors and business practitioners, cash flow is the main measure of financial performance since money facilitates all the financial operations of the organization (Buckley & Casson, 2010). However, there are other measures of investment outlooks and business performance such as the liquidity of its assets and their gross profits.
The accounting profits of a company are however not used in fundamental analysis of business since they do not reflect the organization’s ability to honor its economic obligations. In this case, cash flows represent the flow of money in and out of the business; where the outflows represent money spent in investment while the inflows represent the money coming into the organization as the return on investments.For a business entity to be considered successful, it should record higher cash inflows than the cash outflows. This generally means that the returns on investments are higher than the investment capital. The risks are also well analyzed before making an investment decision. For instance, in respect to cash flows being used as a measure of a company’s performance, the value of the currency used by the company today may not be the value of the currency sometime later due to inflation and deflation; caused by reasons beyond the company’s control. Determining the risks involved in a businessinvestment opportunity may be difficult due to the highly dynamic nature of business operations and the policies governing them. Investors should, therefore, estimate the risk levels and determining whether their risk tolerance can accommodate the levels projected.
Risks in business operations cause differences in projected performances and include risks associated with all aspects of the business operations such as operational risk, political risks, regulatory risks, contingent risks, financial risks, and strategic risks.
. Political and regulatory risks affect business performance almost in a similar way and result from changes in the regulations and the policies governing the operations. Contingent risks involve the occurrence of a possible negative event such as a terrorist attack or a natural disaster which shall directly affect the nature of the business operations. Operational risks arise from changes and difficulties in the managerial operations of the company which adversely exposes the company. Financial risks affecting the business may arise from changes in currency exchange and interest rates while strategic risk may occur due to changes such as the technology primarily used by the company for production becoming obsolete.
Investors have different criterions of making decisions related to their investment decisions (Tzeng & Jih-Jeng, 2011). To determine the viability of a capital project and the most appropriate project to invest in, many investors use capital budgeting techniques to make those critical decisions. These tools are the investment appraisal tools and utilize two conventional methods namely; discounting approach and no-discounting approaches. Discounting approaches work by taking into consideration the time value of money while the non-discounting approach does not consider the concept of time value attached to money. Discounting approach considers the current value of monetary assets and project into prospects by using the internal rate ofreturn. Non-discounted methods use the estimated return periods and the accounting rate of return.
The static decision-making technique does not consider the time value of money but only the cash flows (Tzeng & Jih-Jeng, 2011). They completely ignore the risks associated with the venture. They largely consider the investments’ estimated return period which could be misleading as it does not take into account the time value of money. The dynamic criterion of decision making by investors puts into account the events that may occur and are out of control of the investor.
References
Armstrong, C. S., Guay, W. R. & Weber, P. J. (2010). The role of information and financial reporting in corporate in corporate governance and debt contracting . Journal of Accounting and Economics, vol. 50, issue 2-3, 179 – 234.
Buckley P.J. & Casson M. (2010) The Optimal Timing of a Foreign Direct Investment. In: The
Multinational Enterprise Revisited. Palgrave Macmillan, London
Fahlenbrach, R. (2009). Founder-CEOs, investment decisions, and stock market perfomance.
Journal of Financial and Quantitative Analysis, Volume 44, Issue 2, pp. 439-466
Ogbonna, G. N. & Ebimobowei, A. (2011). Ethical compliance by the accountant on the quality of financial reporting and perfomance of quoted companies in Nigeria. Asian Journal of Business Management 3(3): 152-160
Tzeng, G. H. & Jih-Jeng, H. (2011). Multiple attribute decision making: methods and applications. CRC Press
