WHAT MAKES AN INVESTMENT ATTRACTIVE?
This is the first of a number of articles that
attempt to explain the significance of the basic financial computations needed
to make investment decisions. The purpose is to make this topic understandable
to anyone regardless of his previous knowledge on the subject. It is highly
recommended for the articles to be read in the order they are posted. Let us
begin.
We do business to make money. The objective is
to invest a certain amount with the expectation of getting a larger amount in
the future. But when considering an investment opportunity is not enough that
we get more than we invested but there are two other important factors: time
and risk.
It is not the same to receive €100 within a
year than in 10 years. Naturally the sooner the proceeds are received the
happier we will be. This is what we mean when we speak of the time factor.
The risk factor refers to the fact that the
riskier a business is the higher must be its return. Otherwise, no one would
invest in risky ventures. We would all limit ourselves to invest in the safest
opportunities.
In conclusion. When deciding on an investment
opportunity attention must be given to: 1) the amount of money we get in
exchange for the sum originally invested, 2) how long it will take to receive
the money and, 3) what is the risk involved.
I will illustrate with an example. Let's start
with the first factor: the amount of money to receive.
Suppose we have the opportunity to invest €100 with the expectation of getting €110 in a year, i.e. a yield of 10%. And we also have the opportunity to invest the same €100 but with a 15% yield meaning €115 at the end of the year. Both alternatives have the same risk. Which alternative will be preferable? Obviously the one yielding 15%.
Suppose we have the opportunity to invest €100 with the expectation of getting €110 in a year, i.e. a yield of 10%. And we also have the opportunity to invest the same €100 but with a 15% yield meaning €115 at the end of the year. Both alternatives have the same risk. Which alternative will be preferable? Obviously the one yielding 15%.
Then we reach our first conclusion: If the
risk level is the same, an investment will be more attractive the more money it
produces or, in other words, the higher its yield.
Now let´s look at the second factor: the time
when we will receive the money. Returning to our initial investment
opportunity: investing €100 with the expectation of receiving €110 in a year. Will
we mind if the €110 is received instead at the end of two years? We surely will.
The sooner we get the €110 the happier we will be.
This is because the sooner you get the money,
the quicker it can be reinvested getting even more money in the end. For
example, if we receive €110 in one year this amount can be invested again
during the second year, say at the same 10%. This will produce an additional 10%
during the second year, i.e. €11 (10% of €110). So at the end of the second
year we will get the original €110 plus €11 for a total of €121. There is no
doubt that this is better than receiving just €110 at the end of two years.
This brings us to our second conclusion: An
investment will be more attractive the sooner the money is received.
Let's finish with the third factor: risk. Our
initial investment opportunity promised a return of 10% at the end of a year
for an investment of €100. At first glance it looks good. But is this
attractive enough given the risk taken?
If we were investing in a bond issued by a
very solid company, for example IBM, we are talking about a very attractive
investment. Why? If it is known that IBM normally borrows at an interest rate
of 6%, and we have the opportunity to buy a bond of the same company with a
yield of 10%, there is no doubt that we would be doing a great business.
But if instead it were a bond issued by a Pakistani
construction company, possibly a return of 10% would be insufficient. A
Pakistani company is far riskier than IBM. We would have to ask: How solvent is
the company? Will it pay its debts? Might I lose my money if the company
invests in dangerous ventures? Will the Pakistani rupee lose value? How many
euros will I get if the rupee is devalued?
That is, the Pakistani company will demand a
return larger than 10% since we could always get 10% with IBM which is much
less risky.
This brings us to our third and final
conclusion: The more risky an investment is the larger must its return be.
In the next article I will explain how to
implement these ideas when deciding on an investment opportunity.
