Tutorial Answer

Topics: Investment, Risk aversion, Variance Pages: 7 (1577 words) Published: April 24, 2013





a The process of investment concerns the purchase of assets which will provide a future return to allow for future consumption or further investment. Individuals have to make choices between current and future consumption and because their pattern of income does not always match their pattern of consumption, they are required to make investments. Throughout an individual’s life, an amount of wealth is required to maintain variable levels of consumption. The level of wealth also varies over time. At any point in time, the current level of desired consumption may exceed the current level of wealth. In these circumstances, the individual must obtain additional resources from another to satisfy their consumption needs. That is, the individual must borrow. However, at other points in time, the current level of desired consumption may fall below the current level of wealth. In these circumstances, the individual will save their excess wealth. Typically, this excess wealth is used to purchase an asset, which will yield a future return of wealth, which involves investment.

b The assets into which savings are put represent investment assets. These assets may be financial assets such as shares, bonds or bills or physical assets such as real estate, motor vehicles or art collections. Intangible assets such as human capital are also sometimes referred to as an investment asset.

c The rate of return between future consumption and current consumption is known as the pure rate of interest.

d Given that an investment represents a delay in current consumption, an investor requires a return to compensate for the lost consumption opportunity. This return is required to induce an individual to forgo money (and consumption) now and defer the money (and consumption) to a future date. This return reflects the time value of money.

e In times of inflation, future prices are expected to rise, meaning that a dollar today can command greater purchasing power than a dollar tomorrow. Investors require a return to compensate them for the loss in purchasing power caused by the rate of inflation, which is expected over the period of the investment (e.g. the CPI is often used as a measure of inflation in Australia.

f Investors face trade-offs between expected return and risk. A risk-averse investor prefers less risk to more risk and therefore will select the investment offering the lower risk given the same expected return.

g Risk tolerance refers to the investor’s preference for risk. As such it is closely related to the concept of risk aversion. Investors with high-risk aversion have a low-risk tolerance and hence may have a preference for low-risk investments. The reverse is true of low-risk aversion or high-risk tolerant investors.


The steps (or stages) in the investment process can be broadly described as the allocation decision, performance evaluation and review stages. These stages are described in Figure 1.1:

The allocation process is concerned with how to allocate funds from the investment pool across the various available assets. This decision logically needs to take into account any preferences the investor has for risk and holding period, as to and how these assets will be subsequently managed. After the allocation has been made, the performance of the investment is evaluated and reviewed before a revised allocation is made for subsequent investment periods.


The expected return is the return that an investor expects to receive from an asset over the period of the investment. In comparison, the realised return is the return, which is actually earned over the period of the investment. The expected return and the realised return are only ever equal if expectations are met. In many...
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