Investment Decision-Making & Performance Evaluation

TAKEAWAYS:

• Investment decisions follow a structured 5-step process: screening → analysis → selection → implementation → monitoring.
• Performance metrics (Sharpe, Treynor, Jenson’s Alpha) adjust returns for risk—higher values mean better risk-adjusted performance.
• Taxes, economic cycles, and investor life stages critically shape investment choices (e.g., retirement vs. growth phases).
• Nepal’s investment environment (NEPSE, mutual funds, bank deposits) requires adjustments for inflation, liquidity risks, and regulatory constraints.
• Post-investment evaluation uses benchmarks (market indices, peer portfolios) to assess success or failure.

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1. The Investment Decision-Making Process

Investment decisions are not random—they follow a logical sequence from identifying opportunities to monitoring outcomes. Below is the step-by-step framework used by professionals (and examiners expect you to recall this order!):

Step 1: Screening

• Goal: Narrow down potential investments from a universe of options.
• Tools:
  • Top-down approach: Start with macroeconomic trends (e.g., Nepal’s GDP growth, interest rates) → sector analysis (e.g., fintech vs. real estate) → specific stocks/bonds.
  • Bottom-up approach: Focus on company fundamentals (e.g., Ncell’s revenue growth, Daraz’s profit margins).
• Real-world example:
  • eSewa screens for low-risk, high-liquidity investments (e.g., government securities) to ensure quick payouts for utility bill payments.
  • Khalti prioritizes diversified portfolios (stocks + bonds) to manage risk while offering instant transfers.

Step 2: Analysis

• Quantitative tools:
  • Financial ratios: P/E, P/B, dividend yield (e.g., NEPSE’s average P/E ratio in 2023 was ~18x).
  • Discounted Cash Flow (DCF): Valuing a project (e.g., a new Daraz warehouse) by estimating future cash flows.
  • Risk metrics: Beta, standard deviation, Value at Risk (VaR).
• Qualitative factors:
  • Management quality (e.g., NTC’s leadership vs. private telecom firms).
  • Regulatory environment (e.g., SEBON rules for mutual funds in Nepal).

Step 3: Selection

• Portfolio construction:
  • Diversification: Mix assets (e.g., 60% stocks, 30% bonds, 10% gold) to reduce unsystematic risk.
  • Asset allocation: Adjust based on risk tolerance (e.g., retirees prefer bonds; young investors take equity risk).
• Nepal-specific considerations:
  • Liquidity needs: Pathao drivers may prefer short-term deposits over long-term stocks.
  • Tax efficiency: Mutual funds in Nepal offer tax benefits under Section 42(1)(a) of the Income Tax Act.

Step 4: Implementation

• Execution:
  • Buy/sell orders (market vs. limit orders).
  • Cost management (brokerage fees: ~0.5% in NEPSE vs. 0.1% in global markets).
• Real-world trace:
  • NEPSE IPO example: When NMB Bank went public in 2019, investors had to decide between:
    • Subscription at issue price (Rs. 100): Lower risk but limited upside.
    • Buying post-IPO: Higher risk but potential for capital gains if earnings grow.

Step 5: Monitoring & Evaluation

• Performance tracking:
  • Compare actual returns vs. benchmarks (e.g., NEPSE All Share Index).
  • Adjust portfolio if goals change (e.g., switching from growth to income stocks in retirement).
• Nepal’s challenges:
  • Inflation: Erodes real returns (e.g., a 10% nominal return in 2023 may only be 5% real).
  • Liquidity crises: Sudden sell-offs (e.g., 2020 COVID-19 crash) require quick rebalancing.

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2. Performance Evaluation Metrics

How do you know if an investment is "good"? Raw returns aren’t enough—you must adjust for risk. Here are the key metrics examiners love:

Worked Example: Comparing Portfolios A, B, and C (From past exam questions) Given:

• Risk-free rate ($R_f$) = 5%
• Portfolio returns and betas:

Calculations:

1. Sharpe Ratio:

   • A: $(16-5)/12=0.92$
   • B: $(14-5)/5=1.80$
   • C: $(11-5)/7\approx 0.86$ → Portfolio B wins (highest risk-adjusted return).

2. Treynor Ratio:

   • A: $(16-5)/1.15\approx 9.57$
   • B: $(14-5)/1.05\approx 8.57$
   • C: $(11-5)/0.80\approx 7.50$ → Portfolio A wins (better reward per unit of systematic risk).

Why the difference?

• Sharpe favors low-volatility portfolios (B has low std dev).
• Treynor favors high-beta portfolios (A has higher beta).

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3. Real-World Applications in Nepal

Example 1: NEPSE Investors

• Problem: Many small investors in Nepal rely on dividend income from stocks like NMB Bank or Global IME.
• Decision process:
  1. Screen: High-dividend-yield stocks (e.g., 8%+ yield).
  2. Analyze: Check if dividends are sustainable (payout ratio < 60%).
  3. Select: Diversify across sectors (banks, hydropower, FMCG).
  4. Monitor: Adjust if NEPSE’s P/E ratio rises above historical averages (e.g., >20x).

Example 2: Bank Loans (Interest Rate vs. Inflation)

• Scenario: You take a Rs. 1,000,000 loan at 10% annual interest for 5 years.
• Question: Is this a good investment if you could earn 8% in a mutual fund?
• Calculation:
  • Loan repayment: Rs. 1,000,000 × $(1.10{)}^5\approx \ast \ast Rs.1,610,510\ast \ast$.
  • Opportunity cost: Rs. 1,000,000 × ((1.08)^5 ≈ Rs. 1,469,330 in mutual funds.
  • Net loss: Rs. 161,180 (loan is worse unless you must borrow for business growth).

Example 3: Mutual Funds in Nepal

• Product: NMB Mutual Fund – Equity Scheme (top performer in 2023).
• How it uses performance metrics:
  • Sharpe Ratio: 1.3 (beats NEPSE’s average of 0.9).
  • Alpha: +4% vs. NEPSE index.
  • Tax benefit: Long-term capital gains taxed at 10% (vs. 25% for direct stocks).

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4. Factors Affecting Investment Decisions

A. Taxes

• Nepal’s tax regime:
  • Short-term capital gains: Taxed at slab rates (10%–30%).
  • Long-term capital gains: 10% (if held >1 year).
  • Dividends: Taxed at source (10% for individuals).
• Strategy: Hold investments for >1 year to reduce tax burden.

B. Investor Life Cycle

C. Economic Environment

• Inflation: Erode returns (e.g., 2022 Nepal inflation = 8.5% → real returns = nominal – 8.5%).
• Interest rates: High rates (e.g., 7%–9% in 2023) favor fixed-income (bonds, deposits).
• Political stability: Uncertainty (e.g., election years) increases liquidity preference.

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5. Investment Planning in Nepal

Step-by-Step Plan

1. Define goals:
   • Short-term (1–3 years): Emergency fund (e.g., Rs. 500,000 in a fixed deposit).
   • Long-term (5–10 years): Retirement (e.g., NMB Pension Fund).
2. Assess risk tolerance:
   • Use questionnaires (e.g., NMB’s risk profiling tool).
3. Asset allocation:
   • Conservative: 70% debt, 30% equity.
   • Aggressive: 90% equity, 10% debt.
4. Diversify:
   • Geographic: NEPSE + global ETFs (e.g., Vanguard S&P 500).
   • Asset class: Stocks + bonds + real estate + gold.
5. Review annually:
   • Rebalance if allocations drift (e.g., stocks grow to 80% → sell some to return to 60%).

Nepal-Specific Tools

• eSewa/Khalti: Auto-invest in mutual funds via standing instructions.
• NMB/Global IME: Robo-advisory services for passive investors.
• NEPSE website: Free access to historical returns, P/E ratios, and dividend yields.

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Exam Tip

1. Process questions (e.g., "Describe the investment decision process"):

   • Must mention all 5 steps (screening → monitoring).
   • Use Nepal examples (e.g., "A Khalti user would screen for liquidity first...").

2. Metric calculations (e.g., Sharpe, Treynor):

   • Show formulas and plug in numbers neatly.
   • Compare portfolios (e.g., "Portfolio B is better for risk-averse investors...").

3. Real-world applications:

   • Link to NEPSE, banks, or mutual funds (examiners love this).
   • Calculate opportunity costs (e.g., "A loan at 10% vs. a mutual fund at 8%...").

4. Avoid common mistakes:

   • ❌ Saying "high return = good" without adjusting for risk.
   • ❌ Ignoring taxes/inflation in Nepal-specific questions.
   • ❌ Forgetting to interpret results (e.g., "Thus, Portfolio A is optimal for aggressive investors...").

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Final Visual Summary