Understanding investment process is necessary for all investors for it will serve as basic guide on where, when, and how much to invest. The first part of the process is all about the identification of needs and preferences, understanding the sequence of actions, predefined investing strategies and philosophies, and the components of strategy in the execution of the process. The second part is the actual construction of investment portfolio in order to minimize risk. Creating portfolio involved asset allocation, asset selection decision, and asset execution. In asset allocation, the investors will decide on what marketable securities will he be investing, either in equities, fixed-income securities, and real assets (physical or identifiable assets). After the allocation, investors need to select on what are his asset preferences between stocks, bonds, and many more. The selection will be followed by the execution of investment portfolio and investment strategy. The final part of the process is performance evaluation wherein investment is constantly monitored by the investors themselves or through a portfolio manager.
The Four Investments for Consideration in any Investment Portfolio
Bonds (Municipal & Corporate). It is a debt instrument with specific return, interest and principal, and maturity date. Municipal bonds are debt securities issued by the government level whose maturity date is in a long-term basis. These bonds are considered to be secured and these are issued in order to support government operations and projects for the common good. Municipal bonds are known to be tax-exempt but it depends upon the purpose and jurisdiction. Corporate bonds are debt securities issued by corporations or business firms to finance variety of private purposes. These bonds are subject to a much higher interest rate for it is a risky investment.
Stocks (Common and Preferred). These are issued securities that represent ownership. Ownership through the purchased of stocks are called stockholders which these are represented by stock certificates. Usually, stock prices of companies who are financially stable are high compared to those who are poor in performance because the higher is the value of the stocks the greater is the return of investment. There are two types of stocks, the common and the preferred stocks. In terms of the declaration of dividend and bankruptcy, preferred stockholders are satisfied first before the common shareholders. Both stocks running after income, the only difference is the risk involved. Preferred stocks are less risky but the growth income is fairly dependable while common stocks assumed higher risk but unlimited growth in income and capital gain.
Mutual Funds. It is an investment that used money "from a group of people with
common investment goals to buy securities such as stocks, bond, money market instruments, a combination of these investments, or other funds". These groups of investment securities are put together in a portfolio and it is appropriately managed by a portfolio manager. More often, investors prefer to invest in mutual funds because of access to a diversified portfolio, liquidity, and expertise by professional fund managers; however, mutual funds shared almost the same risk with investment in individual stocks, and drawbacks are always present.
Derivatives. It is a financial instruments based on financial measurement of other assets that usually comes in contracts. Some of derivative instruments are forward, future, options, and swaps. The value of derivatives is based on the prices of some underlying assets or instruments. It also involved contracts between a seller and a buyer wherein the value is based on bargaining power.
Risk and Return Issues with the Portfolio
Most investors invest in several stocks or multiple investment vehicles so that risk will be diversified. Risk is measured by standard deviation that is why investors invest on stocks which are low in standard deviation but with a high value of expected return. Efficient portfolio is hard to construct because a portfolio with a high expected return is also high in standard deviation. In other words, the riskier is the portfolio, the more it is profitable. If this would be the case, the return of a single investment portfolio depends upon the willingness of an investor to take the risk; however, most investors are risk-averse wherein they do not tolerate on becoming worthless in exchange for high returns. In practice, portfolio risk and return are calculated through estimation in order to make an optimal portfolio but this is the common source of mistakes among investors for expected returns are difficult to estimate in a market that changes any time for any reason. To find an optimum balance between risk and return in every portfolio, there should have an evidently structured investment process.
Rationale for each of the Portfolio Selections
Investors invested for bonds because of specific expected return and aside from retrieving their investment, they also gain interests from borrowers. However, the gain for bonds is relatively small and their prices are difficult to estimate due to its constant movement. Stock investment is considered to be the best investment for it is the most profitable. Mutual fund is a safe investment and good for those who are risk-averse; however, its costs are seemed to be too much. On the other hand, derivatives are not actual purchases for most of them are based on contracts, and not all investment transactions will be completed after all. Finally, creating an efficient at the same time safe investment portfolio largely depends on the investors' investment decision because all investments have drawbacks.