This document discusses investment decisions and the investment process. It covers several key points: 1. Investing allows individuals to increase future consumption by earning returns on savings over time. Not investing means savings earn no returns and lose value to inflation. 2. Investing has risks like sacrifice of current consumption, inflation risk, and investment risk. Investors require compensation for these risks in the form of expected returns. 3. The investment decision process involves security analysis like fundamental valuation of individual assets, and portfolio management like constructing a diversified portfolio and managing it over time with either a passive or active strategy. 4. Common errors include misunderstanding of risk and return, not having a clear investment policy, making

1. Investment Management
Chapter 3-The Basic of
Investment Decisions
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2. Why to invest?
Investment increases future consumption
possibilities
• By foregoing consumption today and investing
the savings, investors expect to increase their
future consumption possibilities by increasing their
wealth
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3. Ifwe do not invest, then?
If we have savings and we do not invest, we
can’t earn anything on our savings.
Second, the purchasing power of cash
diminishes in inflation
This means that if savers do not invest their
savings, they will not only lose possible return on
their savings, but will also lose value of their
money due to inflation
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4. But investment has problems
Investment has the following three problems:
A. Sacrifice - While investing, investor delay their
current consumption (delaying consumption is
kind of sacrifice)
B. Inflation - Investment loses value in periods of
inflation
C. Risk - giving your money to someone else
involves risk
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5. Compensation to investors
Due to the three problems, investors will not
invest until they are compensated for these
problems
Required rate of return =compensation for
(sacrifice , inflation, risk)
RRR= opportunity cost +risk premium
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6. Understanding the investment decision
process
The basis of all investment decisions is to earn
return and assume risk
By investing, investors expect to earn a return
(expected return)
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7. Expected return and risk
Realized returns(actual return) might be more or
less than the expected return
The chance that the actual return on an
investment will be different from the expected
return is called risk
This way T-bills has no risk as the expected return
and actual return are the same
But actual returns on common stock have
greater chances of deviating from expected
return and hence have high risk
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8. The expected risk-return trade-off
(Figure 3.1)
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9. The expected risk-return is depicted in the graph
The line from RFR shows risk-return relationship of
different investment alternatives.
I
t shows that at zero level of risk, investor can
earn risk free rate (RFR) which i
s equal to the
rate on T-bills
 To earn a little higher return than the risk free
rate, investors can invest in corporate bonds,
but the investors will have to take some risk as
well
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10. Ex-ante and ex-post risk-return
To earn even higher return than on corporate
bonds, investor can invest in common stocks,
but the risk is also high
The risk return trade-off depicted in the graph in
ex-ante i.e. before the fact or before the
investment is made
Ex-post (after fact or actual) trade-off may be
positive, flat or even negative
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11. Different approaches to investment
decision making
Fundamental Approach: Believed that there is
an intrinsic value of a security that can be
company, industry and economy.
Psychological Approach: This approach based
on the premises that stock prices are guided by
the emotions. Itis more important to analyze
that how investor tend to behave as the market
is swept by the waves of optimism and
pessimism.
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12. Different approaches to investment
decision making
Academic Approach: Suggest that:
• Stock market is efficient in reacting quickly and
rationally hence it reflects intrinsic value fairly well.
• Stock price behavior correspond to the random
walk, hence past price behavior can not be used
to predict the future price.
• There is positive relationship between risk and
return.
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13. Different approaches to investment
decision making
Electric Approach: This approach draws on all
the three approaches.
• Fundamental analysis is helpful in establishing
basic standard benchmarks.
• Technical analysis is useful in broadly gauging the
mood of the investor.
• there is a strong correlation between risk and
return.
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14. Steps in the decision process
Traditionally, the investment decision process
has been structured using two-steps:
• Security analysis
• Portfolio management
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15. Security Analysis
Security analysis: this is the first part of investment
decision process
• Itinvolves the analysis and valuation of individual
securities
• To analyze securities, it is important to understand
the characteristics of the various securities and
the factors that affect them
• Then valuation model is applied to find out their
value or price
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16. • Value of a security is a function of estimated
future earnings from the security and the risk
attached
• For securities valuation, investors must deal with
economy, industry or the individual company
• Both the expected return and risk must be
estimated keeping in view the economic, market
or company related factors
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17. Portfolio Management
The second major component of the decision
processes is portfolio management
• After securities have been analyzed and valued,
portfolio of selected securities is made
• Once a portfolio is made, it is managed with the
passage of time
• For management, there can be two approaches
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18. Approaches to portfolio management:
A. Passive investment strategy
B. Active investment strategy
• In Passive Strategy, investors make few
changes in the portfolio so that transactions
costs, time and search costs are minimum
• In Active Strategy, investors believe that they
can earn better returns by actively making
changes in the portfolio
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19. Common Errors in Investment Decision
Making
Inadequate comprehension of return and risk.
Investor do not has correct understanding of risk
& return and misled by:
• Tall and unjustified claims made by people.
• Exceptional performance of some portfolios due
to fortuitous factors.
• promises made by the tipsters, operators etc.
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20. Investment policy is not clearly defined
• Investment policy and risk disposition is not clearly
spelled out.
• conservative investors become aggressive when
the market is bullish.
• Aggressive investor become over cautious in
bearish market.
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21. Naïve exploration of the past
• Investor is inexperienced and excessively rely on
the past
Cursory of decision making
• Decision are taken on tips and fads rather than
on thoughtful assessment.
• Risks are not considered as greed overpower.
• Try to follow bandwagon decisions due to lake of
confidence in their own judgment.
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22. Stock switching
• Irrational start-and-stop.
• Entry (after the market advance has long been
underway)
• Exit (after a long period of stagnation and
decline)
High Cost Love for a cheap stock
• Cost of transaction is ignored in the greed of
quick profits
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23. Over and Under-diversification
• Over diversification caused difficulties and
excessive cost in portfolio management.
• Under diversification exposes to risk.
Wrong attitude towards profit and losses
• Investor try to dilute the loses by averaging the
price of its holdings.
• Try to sell when the prices more or less equal to
holding price even there are chances of further
increase.
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