There is a trade-off between expected return and risk that should prevail in a rational environment. Investors unwilling to assume risk must be satisfied with the risk-free rate of return. If they wish to try to earn a larger rate of return, they must be willing to assume a larger risk as represented by moving up the expected retum-risk trade-off into the wide range of financial assets available to investors.

Although all rational investors like returns and dislike risk, they are satisfied by quite different levels of expected return and risk. Put differently, investors have different limits on the amount of risk they are willing to assume and, therefore, the amount of return that can realistically be expected. In economic terms, the explanation for these differences in preferences is that rational investors strive to maximize their utility, the perception of which varies among investors.

Always remember that the risk-return trade-off is ex ante, meaning "before the fact." That is, before the investment is actually made, the investor expects higher returns from assets that have a higher risk. This is the only sensible expectation for risk-averse investors, who are assumed to constitute the majority of all investors. Ex post (meaning "after the fact" or when it is known what has occurred), for a given period of time, such as a month or a year or even longer, the trade-off may turn out to be flat or even negative. Such is the nature of risky investments Investors can choose from a wide range of securities in their attempt to maximize the expected returns from these opportunities. They face constraints, however, the most pervasive of which is risk. Traditionally, investors have analyzed and managed securities using a broad two-step process: security analysis and portfolio management.

The first part of the investment decision process involves the valuation and analysis of individual securities, which is referred to as security analysis. Professional security analysts are usually employed by institutional investors. Of course, there are also millions of amateur security analysts in the form of individual investors.

The valuation of securities is a time-consuming and difficult job. First of all, it is necessary to understand the characteristics of the various securities and the factors that affect them. Second, a valuation model is applied to these securities to estimate their price, or value. Value is a function of the expected future returns on a security and the risk attached. Both of these parameters must be estimated and then brought together in a model.

For bonds, the valuation process is relatively easy, because the returns are known and the risk can be approximated from currently available data. This does not mean, however, that all the problems of bond analysis are easily resolved. Interest rates are the primary factor affecting bond prices, but no one can consistently forecast changes in these rates.

The valuation process is much more difficult for common stocks than for bonds. The investor must deal with the overall economy, the industry, and the individual company. Both the expected return and the risk of common stocks must be estimated.

Despite the difficulties, some type of analysis must be performed by investors serious about their portfolios. Unless this is done, one has to rely on personal hunches, suggestions from friends, and recommendations from brokers-all potentially dangerous to one's financial health.

The secondary major component of the decision process is portfolio management. After securities have been evaluated, a portfolio should be selected. Concepts on why and how to build a portfolio are well known. Much of the work in this area is in the form of mathematical and statistical models, which have had a profound effect on the study of investments in this country in the last 30 years.

Having built a portfolio, the astute investor must consider how and when to revise it. This raises a number of important questions. Portfolios must be managed, regardless of whether an investor is active or passive. If the investor pursues an active strategy, the issue of market efficiency must be considered. If prices reflect information quickly and fully, investors should consider how this will affect their buy and sell decisions. Even if investors follow a passive strategy, questions to be considered include taxes, transaction costs, maintenance of the desired risk level, and so on.