Category of Investment Decision Rules

You are aware that any investor has to take decision about the investment, as own funds are involved in the investment. So, you can take investment decision only after analyzing entire process of investment that starts with funds contribution and ends with getting expectations fulfilled. In the sense, you will take decision only after ensuring that the required expectations in terms of returns are ensured at any cost. You are yet to decide whether to invest or not, whenever, you have faced with new investments and projects, though earlier units has lead to take decision.

In this lesson, the investment decision rules allow you to formalize the process and specify what condition or conditions need to be met to accept the project. For example, an investment decision rule may specify that only projects that the amount invested in them, in less than five years will be accepted or only projects that earn a return on capital greater that their cost of capital are good projects.

The characteristics of good investment decision rules are: –

• It should maintain a fair balance between allowing manager to analyze the project and bring-in subjective assessment into the decision and ensuring that different projects and judged consistently.
• It must maximize the value of the firm
• It should work across a variety of investments.

So, an investment decision rule should lead to different conclusions on whether the project should be accepted or rejected. Main rule can be made as primary rule.

The investment decision rule can be categorized in to two broad ways based on the basis of calculation of return: –

• Accounting Income-based decision rule
• Cash flow-based decision rule

Every portfolio manager must follow an investment policy. An investment policy is a statement that helps a manager in running an investor’s portfolio in accordance with investment goals, constraints and objectives. This is needed to keep discipline intact so that at the end of the investment horizon, the returns on portfolio matches the investor’s expectations. Keeping a standard investment policy also helps track the performance of different portfolio managers.

There are certain client situations that an investment policy considers:

• Repercussions of the client hitting adverse financial situations.
• The client’s reaction to such a situation.
• The awareness of the client about investments and markets.
• Any legal restrictions affecting the investor’s investment.

The policy statement should include a benchmark portfolio, or a standard of comparison. It should be made sure that the risk of the benchmark and the assets included in it commensurate with the investor’s risk preference and investment needs. For example, an investor preferring low-risk investment strategy should have a policy statement and should compare the investment manager’s performance against a low-risk benchmark portfolio.