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April 3, 2024

How to make Investment decisions and what factors influence: A Guide for Beginners

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Understanding Investment Decisions: 

Investment decisions involve allocating your financial resources to achieve specific goals.  Investors, both individuals and organisations,  choose the most suitable assets or investment opportunities based on their risk tolerance, investment objectives, and return expectations.

Limited Resources, Strategic Allocation

Organisations have limited financial resources, so senior management makes strategic choices through capital budgeting. This involves allocating funds into long-term assets like property, plant, and equipment.  Managers overseeing day-to-day operations often focus on short-term investments to ensure liquidity and maintain sufficient working capital for ongoing expenses.

Beyond the basic timeframe, several other factors influence investment decisions. These include return frequency, the risks associated with the investment, maturity periods, potential tax benefits, market volatility, and even inflation rates.  While not every investment decision is straightforward, understanding these factors empowers you to make informed choices.

Key Points to Remember:

  • An investment decision is a carefully planned allocation of financial resources aimed at achieving the highest possible return within an acceptable risk tolerance. The decision considers your investment objectives, your risk appetite, and whether you’re an individual or a corporate investor.
  • Investments are primarily categorised as short-term or long-term. They can also be further segmented into strategic investments, capital expenditures, inventory purchases, modernization projects, expansion initiatives, asset replacements, or even investments in entirely new ventures.
  • The investment process typically involves formulating clear investment objectives, determining your risk profile, allocating your assets across different investment options, and then consistently monitoring the performance of your portfolio.

Making Informed Choices: The Investment Process

Investment decisions are ultimately made to maximise returns by allocating financial resources to the right opportunities. These decisions consider two crucial financial management parameters: risks and returns. Investors and managers devote significant time to investment planning, as these choices often involve substantial funds and can be irreversible, impacting investors and businesses in the long term.

A Universe of Investment Options

Both individuals and corporate investors have a wide range of options to consider, including various assets, securities, bonds, debentures, gold, real estate, and more.  For businesses, investments could involve new ventures, projects, mergers, or acquisitions.

Short-Term vs. Long-Term Considerations

Investment decisions are further categorised into short-term and long-term. The final decision may involve a capital expenditure on assets that yield long-term benefits, such as new machinery for a factory, or an investment in inventory that converts into sales within a short period.  A company might pursue expansion by initiating new projects or increasing the capacity of an existing facility. Capital investment is also necessary for replacing outdated assets to maintain efficiency.  Decision-making in business permeates every aspect of operations, and sound investment choices are essential for long-term success.

A Step-by-Step Guide to Investment Decisions

Investing in an asset, security, or project demands patience and a well-defined decision-making process. Here’s a five-step process that guides investors:

  • Analyse Your Financial Position: To manage finances effectively, it’s crucial to grasp your current financial health, whether as an individual or a business. This involves understanding your income streams, liabilities, and overall financial standing.
  • Define Your Investment Objectives: Subsequently, investors must establish clear investment objectives. Are you saving for a short-term goal like a vacation or a long-term goal like retirement? This will also help you gauge your risk appetite, or the level of risk you’re comfortable accepting.
  • Asset Allocation: Depending on your objective and risk tolerance, you’ll need to distribute your assets into various investment options. This could include stocks, debentures, bonds, real estate, options, and commodities. A financial advisor can help you create a diversified portfolio that aligns with your goals.
  • Select Investment Products: After narrowing down to a specific asset class, you’ll need to choose a particular investment or security. Alternatively, this could be a portfolio of assets that meet your requirements.
  • Monitor and Conduct Due Diligence: Once you’ve invested, it’s essential to monitor the performance of each investment and oversee returns. Portfolio managers or individual investors should take prompt action if an investment underperforms expectations.

Factors Influencing Investment Decisions

An investment is a calculated decision, and several factors influence these choices. Here are some key considerations:

  • Investment Objective: The purpose behind an investment determines whether funds are allocated for the short term or long term. It serves as the starting point of the decision-making process.
  • Return on Investment (ROI): Managers prioritise positive returns, endeavouring to invest limited funds in assets or securities with the potential for good returns.
  • Return Frequency: The frequency of periodic returns offered by an investment is crucial. Financial management revolves around meeting financial needs; investors choose between investments that yield monthly, quarterly, semi-annual, or annual returns.
  • Risk Involved: Investments carry varying degrees of risk, categorised as high, medium, or low. Every investor and company has a different risk tolerance, so a thorough risk analysis is essential before making any investment decision.
  • Maturity Period or Investment Tenure: Investments often have a set timeframe where the invested funds are tied up. The maturity period and payback duration significantly influence investor decisions.
  • Tax Benefits: The tax implications associated with a particular asset or security are another critical determinant. Investors naturally tend to shy away from investment opportunities subject to heavy taxation.
  • Safety and Security: Assets or securities offered by reputable companies with a history of transparent financial disclosure are generally considered safer investments. Government-backed assets are typically seen as the most secure.
  • Market Volatility: Market fluctuations can significantly impact investment returns and cannot be disregarded. Investors need to consider their risk tolerance in relation to potential market volatility.
  • Liquidity: Investors often have emergency funds and may need access to their money before the maturity date. Therefore, they evaluate the level of liquidity offered by a specific asset or security, particularly considering withdrawal restrictions and penalties.
  • Inflation Rate: In financial management, investors seek investment opportunities where returns surpass the nation’s inflation rate. This ensures that the purchasing power of their investment keeps pace with the rising cost of goods and services.
  • Illustrative Examples

Let’s look at some examples to illustrate these concepts:

Example #1: Prioritising Safety and Liquidity

Imagine Sarah has $12,000 in her savings account. She wants to invest but prioritises low risk and high liquidity.  Her financial advisor recommends XYZ mutual funds. This mutual fund allocates 75% of her funds into debentures & bonds and 25% into stocks, offering a good balance between risk and return. Additionally, she has the flexibility to withdraw funds at any time.

Example #2: Large-Scale Investment Decisions

Caisse de Dépôt et Placement du Québec (CDPQ) and DP World co-invested $5 billion in three prominent UAE assets: Jebel Ali Port (JAP), Jebel Ali Free Zone (JAFZ), and National Industries Park (NIP). This investment provided CDPQ with exposure to a significant logistics chain encompassing over 8,700 global companies serving more than 3.5 billion consumers worldwide. In 2021, these assets generated an overall revenue of $1.9 billion.

Frequently Asked Questions (FAQs)

What is the investment process?

The investment process in financial management typically involves a five-step approach:

  1. Analysing your current financial condition.
  2. Establishing an investment objective and determining your risk profile.
  3. Planning and implementing asset allocation.
  4. Selecting the appropriate investment opportunity.
  5. Monitoring investment performance and conducting due diligence.

What factors influence investment decisions?

Various factors influence investment decisions, including:

  • Investment objective
  • Return on investment (ROI)
  • Return frequency
  • Risk involved
  • Maturity period
  • Tax benefits
  • Safety and security
  • Market volatility
  • Liquidity
  • Inflation rate

What are the types of investment decisions?

Investment decisions encompass a wide range of possibilities, including:

  • Strategic investment
  • Capital expenditure
  • Inventory investment
  • Modernization investment
  • Replacement investment
  • Expansion investment
  • New venture investment

Why are investment decisions important?

In organisations, investment decisions are pivotal for growth and profitability. They impact cash flows and have long-term repercussions as many are irreversible. Even with limited funds, individuals can achieve impressive returns through well-planned investments.  Carefully assessing the associated risks helps managers avoid potential losses.

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