Investment: the three things that matter
The amount of cash you receive in return for the cash you hand over is usually referred to as the return on your investment. You may expect to get all the return in one go, or you may receive it as a series of payments. On the face of it, the more you get back the happier you are, but of course things are never that simple. There are two other absolutely vital factors that you must take into account. Firstly, there is the question of timing.
Whether you receive your return in one lump, or whether it comes to you as a series of payments, the timing of these payments affects the rate of return on your investment. If you have two otherwise identical investments that both return the same amount of cash but at different times, the one returning it first is the better. When you put money into an investment, you are passing up the opportunity of spending it now, or saving it, or investing it in something else. So as time passes, you are missing out on the interest you could have received had you put the same amount into, for example, a building society account. So whatever return you get in, say, a year’s time is worth less to you than the same amount of money now.
For example, suppose you have an investment that promises to double your money – is that good or bad? One that doubles your investment in a year is giving you a rate of return of 100% per year. The same investment that doubles your money in twenty years is only giving you a rate of return of 3.5% a year, which is about what you might get in a building society at the moment. The one that doubles your money in a year is exceptionally good (on the face of it), whilst doubling your money over twenty years is nothing special.
Suppose we have two investments, both giving a single return at some time in the future. We can have a smaller return sooner, or a larger return if we are prepared to wait longer. How do we decide which is the better? If we are happy to get our money back at the later date, then the choice is between taking the longer term investment and waiting until it pays out, or taking the shorter term one and then reinvesting or saving the cash for the remainder of the time. By discounting the cash we expect to receive in the future, we can compare investments that return different amounts at different times. We will look at this in more detail later, but for now it is enough to realise that when you get your return is just as important as what you get.
You will notice that with these examples I have been careful to say that the investments we are comparing are identical except for the timing and the amount of the payments. I haven’t said anything, yet, about how confident you can be about what you are going to get and when you are going to get it. That brings us to the third vital ingredient – risk.
When you part with your money you are taking a risk. With some investments you can be very confident about the amount and the timing of the returns. For example, the Government guarantees the payments on investments such as National Savings and Government Bonds. However, if you invest in company shares through the Stock Market, there is no guarantee that you will receive anything in return. There is often a reasonable chance that you will, but no certainty. Government Bonds are regarded as being virtually free of risk (governments usually honour their borrowing commitments), whilst shares are regarded as fairly high-risk investments.
Although the question of risk usually applies to the amount and timing of your return, it is worth bearing in mind that inflation represents a risk too. Even if you can be completely confident about what you will receive and when, the value or spending-power of what you receive in the future will not be the same as the value or spending-power of the same amount of money at the time you made the investment. Naturally, the longer it is between when you make an investment and when you receive the return, the greater the risk that inflation over that period will have moved the goal-posts. Some types of investment take account of inflation but this protection comes at a price.
Leaving aside the question of the risk that inflation will eat away at the spending power of the cash we expect to receive, we are still faced with the risk that we may not get the return we expect. For some types of investment there is only one source of risk. For example, if we buy a Government Bond and hold it until it matures, we will receive regular payments plus a lump sum at the end. All of our return and the timing of it are guaranteed by government. Nobody else is involved. But in the case of, say, company shares we may be expecting a regular dividend from the company but also expect to be able to sell the shares in the Stock Market at some time in the future. There are now two sources of risk. There is the risk that the company can’t or won’t pay the dividends we expect, and even if it does, the value that the market places on the shares when we want to sell them might be quite different to the value it placed on them when we bought them.
When people talk about shares as being risky, they are generally referring to the fact that share prices are changing all the time. I can buy a share today and see the price drop tomorrow. Will I be poorer then? If I buy it and see the price rise, will I be richer then? Of course, unless you actually sell the shares tomorrow, you are no richer or poorer than you are today but you probably feel that you are. Before going further into the question of risk, let’s look at returns in more detail.
|9 October, 2008 © 2008 K.R.Wade and Co Ltd|