1. Principles of Financial Decision
Making
1
Maori Expression
“In searching for all the relevant facets of an issue,
therein will lie the understanding that can provide the
solution.”
2
Multiple Goals
In finance there can be many goals.
In U.S. alone, there are over 7,000 mutual funds (and that
many again hedge funds). Each has its own stated goals
and objectives.
Many people have definite goals about:
• how they want their money invested
• where
• by whom
Average vs. non-average investors
3
Managing An Organization
Many ways to judge performance, for instance
• customers
• labor relations
• profits
• community
• environment
• governance
• etc.
4
Solving Problems
Many ways to handle problem, but which is best according
to your goals and objectives? Taking an analytical
approach:
problem
model
loading model with
data and forecasts
decision
science tools
display of candidates for
optimality
financial theory
common sense
intuition
judgment
5
Risk and Return
Have risk vs. return in finance because the outcome is often
an uncertain.
Mathematicians have shown that under reasonable
assumptions, the set of all efficient solutions of
min Variance of return
max  Expected return
s.t. various restrictions and requirements
is precisely the set of all potentially optimal solutions.
Which efficient solution is optimal depends upon one’s
tardeoff between risk and return. Hard to tell optimal
tradeoff in advance. Often best to compute efficient
solutions and decide from there.
6
Efficient Solutions
A (risk, return) combination is efficient (nondominated or
potentially optimal) if there exists no other combination that
dominates it.
That is, preferred in one criterion and no worse in the other.
Risk(min)
expRet(max)
a
b
c
d
e
f
g
h
7
-1
2
2
3
2
8
7
3
5
10
7
4
6
9
4
7
Decision Making Strategy
1. Throw away all inefficient (dominated) solutions
2. Present all efficient solutions to DM
3. Have DM select his or her most preferred efficient
solution
8