What is Investment Decision?
Investment decision refers to financial resource allocation. Investors opt for the most suitable assets or investment opportunities based on risk profiles, investment objectives, and return expectations.
Firms have limited financial resources; therefore, the top-level management undertakes capital budgeting and fund allocation into long-term assets. Managers overseeing business operations opt for short-term investments to ensure liquidity and working capital. Investment decisions are also influenced by the frequency of returns, associated risks, maturity periods, tax benefits, volatility, and inflation rates.
Table of contents
Key Takeaways
- An investment decision is a well-planned action that allocates financial resources to obtain the highest possible return. The decision is made based on investment objectives, risk appetites, and the nature of the investor, i.e., whether they are an individual or a firm.
- Investments are primarily classified into short-term and long-term. Further, they are categorized into a strategic investment, capital expenditure, inventory, modernization, expansion, replacement, or new venture investments.
- The investment process involves the following steps: formulating investment objectives, ascertaining the risk profile, allocating assets, and monitoring performance.
Investment Decision Explained
Investment decisions are made to reap maximum returns by allocating the right financial resource to the right opportunity. These decisions are taken considering two important financial management parameters—risks and returns.
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Investors and managers dedicate a lot of time to investment planning—these decisions involve massive funds and can be irreversible—impact on the investors and business is long-term.
Also, individuals and corporate investors have to decide between various options—assets, securities, bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more, debentures, gold, real estate, etc. For businesses, investments could be in the form of new ventures, projects, mergersMergersMerger refers to a strategic process whereby two or more companies mutually form a new single legal venture. For example, in 2015, ketchup maker H.J. Heinz Co and Kraft Foods Group Inc merged their business to become Kraft Heinz Company, a leading global food and beverage firm.read more, or acquisitionsAcquisitionsAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion.read more as well.
Investment decisions are further classified into short-term and long-term. For example, the final decision may involve a capital expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more on assets that pay off in the long run or an investment in inventory that converts into sales within a short period. A company might attempt expansion by taking up new projects; a business might increase the capacity of an existing facility. Capital investment is required for replacing an obsolete asset as well. In business, decision-making is everywhere.
Process
Investing in an asset, security, or project requires a lot of patience; ideally, the decision-making process should be analytical. Following is a five-step process decision-making process that guides investors:
- Analyze Financial Position: For financial management, one has to understand the company or individual’s current financial condition.
- Define Investment Objective: Then, investors must set up an investment objective—whether to invest short-term or long-term. They should also be aware of their risk appetite (level of risk they desire to take).
- Asset Allocation: Based on the objective, investors must allocate assets into stocks, debentures, bonds, real estateReal EstateAt its most basic principle, Real Estate can be defined as properties that comprise land and its tangible attachments. The land includes the actual surface of the earth and any permanent natural objects such as water, dirt, or rock and any minerals or particulars under the surface. read more, options, and commoditiesCommoditiesA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.read more.
- Select Investment Products: After narrowing down on a particular asset class, investors must further select a particular asset or security. Alternatively, this could be a basket of assets that fit the requirements.
- Monitor and Due Diligence: Portfolio managersPortfolio ManagersA portfolio manager is a financial market expert who strategically designs investment portfolios.read more keep an eye on the performance of each investment and monitor the returns. In case of poor performance, they must take prompt action.
Factors Affecting Investment Decision
An investment is a planned decision, and some of the factors that are responsible for these decisions are as follows:
- Investment Objective: The purpose behind an investment determines the short-term or long-term fund allocation. It is the starting point of the decision-making process.
- Return on Investment: Managers prioritize positive returns—they try to employ limited funds in a profitable asset or security.
- Return Frequency: The number of periodic returns an investment offer is crucial. Financial management is based on financial needs; investors choose between investments that yield monthly, quarterly, semi-annual, or annual returns.
- Risk Involved: An investment may possess high, medium, or low risk, and the risk appetite of every investor and company is different. Therefore, every investment requires a risk analysis.
- Maturity Period or Investment Tenure: InvestmentsInvestmentsInvestments are typically assets bought at present with the expectation of higher returns in the future. Its consumption is foregone now for benefits that investors can reap from it later.read more pay off when funds are blocked for a certain period. Thus, investor decisions are influenced by the maturity period and payback periodPayback PeriodThe payback period refers to the time that a project or investment takes to compensate for its total initial cost. In other words, it is the duration an investment or project requires to attain the break-even point.read more.
- Tax Benefit: Tax liabilityTax LiabilityTax liability refers to the outstanding amount to be paid by an individual or company to the government. read more associated with a particular asset or security is another crucial deciding factor. Investors tend to avoid investment opportunities that are taxed heavily.
- Safety: An asset or security offered by a company that adheres to regulatory frameworks and has a transparent financial disclosure is considered safe. Government-backed assets are considered the most secure.
- Volatility: Market fluctuations significantly affect investment returns and, therefore, cannot be overlooked.
- Liquidity: Investors are often worried about their emergency funds—the provision to withdraw money before maturity. Hence, investors look at the degree of liquidity offered by a particular asset or security; they specifically consider withdrawal restrictions and penalties.
- Inflation Rate: In financial management, investors look for investment opportunities where returns surpass the nation’s inflation rate.
Examples
Example #1
Let us assume that Quinn possesses $12000 in her savings account. She decides to invest, but her priority is low risk and high liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more. Her portfolio manager suggests XYZ mutual funds. This mutual fund allocates 75% of her money into debentures & bonds and 25% into stocks. Also, she can withdraw funds at any time.
Example #2
Caisse de Depot et Placement du Quebec (CDPQ) and DP World plan co-invested $5 billion into three prominent UAE assets:
• Jebel Ali Port (JAP) established a trade corridor between the east and the west,
• Jebel Ali Free Zone (JAFZ) is the world’s largest free zone located in the middle east,
• National Industries Park (NIP) spread its manufacturing and processing companies across 21sq. Km of area.
As a consequence of the investment, CDPQ gained an expansive exposure—a logistics chain comprising 8700 global companies—3.5 billion-plus consumers worldwide. In 2021, these assets yielded an overall revenue of $1.9 billion.
Frequently Asked Questions (FAQs)
In financial management a five-step investment process is followed:
1. Analyze the current financial condition.
2. Set up an investment objective and ascertain the risk profile.
3. Plan and devise asset allocation.
4. Select the appropriate investment opportunity.
5. Monitor investment and perform due diligence.
Given below are the various factors that influence decisions:
1. Investment objective
2. Return on investment
3. Return frequency
4. Involved risks
5. Maturity period
6. Tax benefit
7. Volatility
8. Liquidity
9. Inflation rate
Investment decisions are classified into:
1. Strategic investment
2. Capital expenditure
3. Inventory investment
4. Modernization investment
5. Replacement investment
6. Expansion investment
7. New venture investment
In organizations, investment decisions are crucial for growth and profitability—impact cash flows—have a long-term impact as many of these decisions are irreversible. Even with limited funds, individuals can obtain impressive returns if the investment is well-planned. Managers must calculate the risks associated beforehand; this way, they can avoid losses.
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