An optimal investment of modern individual shareholders also implies a modern portfolio theory. Any investor aims to maximize his returns and minimize the risk. Acting rationally, in fact, maximizing the return for an acceptable level of risk is the thing that always works.
An optimal-risk portfolio is usually determined to be somewhere in the middle of the highest and lowest returns, implying the highest and lowest risks correspondingly. You can achieve a low risk return by investing in risk-free assets like government securities. However, diversifying correctly, investing in the range of possible securities from a high to a low risk potential will still more likely guarantee an average and, therefore, an optimal investment of yours.
You can choose how much volatility you are willing to bear in your portfolio by picking any other point that falls on the efficient frontier. It will enable you with the maximum return for the amount of risk you wish to accept. As far as optimizing your portfolio is not something you can calculate in your head, computer programs will help you in determining optimal portfolios by estimating hundreds or even thousands of different expected returns for each given amount of risk.
When considering the risk, you should be aware of an under investment problem, which plays a great role, influencing the price of the shares. In the well-functioning democracy there is an under investment problem unless the government is able to commit to its regulated price before an investment is made. The price regulation provides strong incentives for the efficiency. If there is no commitment on regulating prices in the country, the under investment problem can be solved as well. The pricing decision in this case is to be delegated to an independent regulator, whose preferences do not necessarily coincide with those of the government. The independence of the regulator allows the decisions not to be over-ruled after the sunk investment has been made by the firm.
New perspectives are provided on the under-investment problem in the regulation of a firm with the market power. You may observe the governmental price regulation that encourages a socially optimal investment. First, there is less that the total electoral transparency in which voters receive an optimal amount of information, and second, the decisions on price are delegated to a sufficient pro-industry regulator. The risk and partial irreversibility can generate an option value to waiting to invest. It might be a source of underinvestment. If an investment in regulated sectors is crucial for the development of a country, some mechanisms to alleviate the under investment becomes necessary. If the country already has a high level of physical infrastructure, the mechanisms to alleviate the under-investment become less important.
Determining your appropriate asset mix and maintaining it may serve to your optimal investment task of appropriately allocating your available investment funds among different assets classes. The asset allocation is a strategy of dividing your total investment portfolio among various asset classes, such as stocks, bonds and money market securities. Essentially, the asset allocation is an organized and effective method of diversification.
The stocks, markets and bonds for you to choose from, when creating your optimal portfolio, are determined in the following way:
- Large-cap stock - shares, issued by large companies with the market capitalization, are generally greater than ten billion dollars.
- Mid-cap stock, issued by mid-sized companies with the market cap, is generally between two billion dollars and ten billion dollars.
- Small-cap stocks - representing smaller-sized companies with the market cap of less than two billion dollars. These types of equities tend to have the highest risk due to the lower liquidity.
- International securities are issued by foreign companies and listed on a foreign exchange. International securities will help you diversify outside your country, but they also do not guarantee that a country will be able to honor its financial commitments.
- Emerging markets represent securities from the financial markets of a developing country. Although investments in emerging markets offer a higher potential return, there is also a higher risk, often due to the political instability, country risk and lower liquidity.
- Fixed-income securities are debt securities that pay a holder a set amount of interest, periodically or at maturity, as well as the return of the principal, when the security matures. Fixed-income securities have lower volatility than equities and have a lower risk due to a steady income they provide. Anyhow, the risk of default is still present here, and in this case, the promises of an issuer will not help you get your returns back. Fixed-income securities include corporate and government bonds.
- Money market securities are extremely liquid debt securities with maturities of less than one year. Treasury bills make up the majority of these types of securities.
- Real-estate investment trusts (REITs) will help you trade similarly to equities, except the underlying asset is a share of a pool of mortgages or properties, rather than the ownership of a company.
Certainly, choosing on where to invest in and also knowing the risk-return characteristics of the various asset classes will help you to maximize returns and minimize risks.