Global Investment Analysis

By M. Isi Eromosele

Some investments can be very successful.

However, the world of investments is plagued by uncertainty and unpredictability. No matter how sophisticated investment tools are, or how much rigorous a research is done into potential investments, it is not possible for an investor to predict the future. And that, in a nutshell, is why investment analysis is vital.

Investment analysis encompasses a methodology for accommodating the fundamental uncertainty of the financial world. It provides the tools that an investor can employ to evaluate the implications of their portfolio decisions and gives guidance on the factors that should be taken into consideration when choosing a portfolio. Investment analysis cannot eliminate uncertainty, but it can show how to reduce it.

The starting point for investment analysis is the market data on the values of securities which describes how they have performed in the past. This market data can be taken as given or it can be studied to form a foundation for how you should invest on the basis of that data. This generates a set of tools which, even if an investor does not apply them literally, provide a powerful framework in which to think rationally about impending investments.

A serious investor will want to go beyond just accepting market data and progress to an understanding of the forces that shaped that data. This is the role of financial theories that investigate explanations for what is observed.

The deeper understanding of the market encouraged by theory can benefit an investor by, at the very least, preventing costly mistakes. The latter is especially true in the world of derivative securities.

But a theory remains just that until it has been shown to unequivocally fit the data, and the wise investor should never forget the limitations of theoretical explanations in finances.

Investment Analysis

There are the institutional facts about financial securities: how to trade and what assets there are to trade. Secondly, there are analytical issues involved in studying these securities: the calculation of risks and returns and the relationship between the two.

Then there is the question of what success means for an investor and the investment strategies that ensure the choices made are successful. Finally, there are the financial theories that are necessary to try to understand how the markets work and how the prices of assets are determined.

A knowledge of investment analysis can be valuable in two different ways. It can be beneficial from a personal level. The modern economy is characterized by ever increasing financial complexity and extension of the range of available securities.

Moreover, personal wealth is increasing, leading to more funds that private individuals must invest. There is also a continuing trend towards greater reliance on individual provision for retirement. The wealth required for retirement must be accumulated whilst working and be efficiently invested.

Securities

From an investor’s perspective, the two most crucial characteristics of a security are the return it promises and the risk inherent in the return. An informal description of return is that it is the gain made from an investment and of risk that it is the variability in the return.

The return on a security is the fundamental reason for wishing to hold it. The return is determined by the payments made during the lifetime of the security plus the increase in the security’s value.

The importance of risk comes from the fact that the return on most securities (if not all) is not known with certainty when the security is purchased. This is because the future value of a security is unknown and its flow of payments may not be certain. The risk of a security is a measure of the size of the variability or uncertainty of its return.

It is a fundamental assumption of investment analysis that investors wish to have more return but do not like risk. Therefore to be encouraged to invest in assets with higher risks, they must be compensated with greater return. This fact, that increased return and increased risk go together, is one of the fundamental features of assets.

Anticipated Returns

When a risky asset is purchased, the return it will deliver over the next holding period is unknown. What is known, or can at least be assessed by an investor, are the possible values that the return can take and their chances of occurrence.

The underlying risk is represented by the future states of the world and the probability assigned to the occurrence of each state. The question then arises as to what guides portfolio selection when the investment decision is made in this environment of risk.

The first step that must be taken is to provide a precise description of the decision problem in order to clarify the relevant issues. The description that is given reduces the decision problem to its simplest form by stripping it of all but the bare essentials.

Consider an investor with a given level of initial wealth. The initial wealth must be invested in a portfolio for a holding period of one unit of time. At the time the portfolio is chosen, the returns on the assets over the next holding period are not known. The investor identifies the future states of the world, the return on each asset in each state of the world, and assigns a probability to the occurrence of each state.

At the end of the holding period, the returns of the assets are realized and the portfolio is liquidated. This determines the final level of wealth. The investor cares only about the success of the investment over the holding period, as measured by their final level of wealth, and does not look any further into the future.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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