INVESTMENT BASICS

Investment Process

Investment Process

Investment Process

The investment process outlines the steps in creating a portfolio, and emphasizes the sequence of actions involved from understanding the investor's risk preferences to asset allocation and selection to performance evaluation. Investors adopt a range of strategies, depending on their objectives. Investments can be made in government securities, bearing minimal, if any, risk of default and earning a low rate of interest. An investor can build a diversified portfolio of stocks, bonds, and cash. Depending on the investor's risk tolerance, this portfolio could be weighted more toward bonds than stocks or vice versa.

The investor would also determine whether the strategy would be to have a growth portfolio, where price appreciation is the goal, or a value portfolio, which stresses the importance of dividends. On the other hand, Warren Buffett advises that investors should seek out a select group of well-managed companies instead of diversifying as prescribed by Markowitz (1952).

Bonds

Bonds represent a claim on the issuer's assets and are a contract with the issuer, as opposed to stocks, which represent ownership that is not contractual. The bond contract, called the indenture, states the terms and conditions of the issue, especially the timing and amounts of the interest payments and principal repayments. Generally, for most corporate and government bonds, interest is paid semiannually.

Corporate bonds are backed by the earning power of the company issuing them, and the decision to include them in the investor's portfolio is generally based on the credit quality of the issue. In most cases involving corporate bonds, investors choose a credit rating that is at least investment grade. The rating of the bond is not the agency's assessment of the overall quality of the company issuing the bonds. Rather, it is the evaluation of the particular bond issue as supported by the company's financial strength, the quality of its management, and its current position in its markets. Bonds with the highest ratings represent the highest creditworthiness of the issuer and will have the lowest interest rate because they have the lowest risk.

Mutual funds

Mutual funds are another possible investment for the portfolio, and they, too, must coincide with the investor's objectives. The Investment Company Institute (ICI, 2008) categorized mutual funds as the following:

Stock funds

Hybrid funds

Taxable bond funds

Municipal bond funds

Taxable money market funds

Nontaxable money market funds

Mutual funds may be open-ended, which means that shares of the fund can be traded at any time. Or funds may be closed-ended, which means that the number of shares in the fund is fixed and can be traded only if the investor can find another investor who wishes to engage in a transaction, either buying into the fund or selling out of it. In addition to incurring management fees, investors in mutual funds may incur fees for purchasing the fund, called loads; reimbursing the fund for marketing expenses, called 12B-1 fees; and trading within the fund.

Preferred stock

Another investment alternative is to purchase preferred stock in some of the larger companies being traded on the New York Stock Exchange and on ...