|
|||
|
|
|
|
|
When most people think of investments they think of stocks or mutual funds. An investment is more than this. An investment requires one to set aside an amount today with the expectation of receiving a larger sum in the future.
Now that was the easy part. The hard part is the actual computation of value and the risks involved in calculating it. (Hey we never said making money was easy on Wall Street, as with anything else it takes hard work). Before we discuss risk and return, lets get your mind ready to invest.
Like I mentioned before, in order to invest and make money, you must be able to buy an investment at a price that is less than its value. Lets say you value a share of XYZ at $10 and the market price is $8. You would buy this stock. If the market price goes down to $6, should you sell? Of course not!
What I'm about to tell you is so fundamental and simple yet many investors, including the pros, do not follow it. When you know the value of something you can feel confident in ignoring daily market PRICE fluctuations. Let me reinforce one final point, investing as with anything else, involves asking two questions. First what is it worth or what is the value to me and lastly, what is the price?
The Rewards
Any investor who lays aside money today expects to get more in return later. How much is more? Well, the best way to calculate this is to look at your rate of return. In its simplest form, you would take the ending value of your investment, divide it by your initial investment, take the n root of it (where n= the number of years you held the investment), and minus one. Confused? Well, let's give an example.
If I invested $100 for three years and after this period it was worth $150, my rate of return would be [150/100^(1/3)]-1=14.47%. Don't worry we'll look at this concept more when we study present and future values.
Now that you have your rate of return you may be asking, "How much is enough?" Well, looking at past market history, equities on average returned 10% annually, small caps 12%, bonds 5%, and t-bills around 3-4%. We will ignore all this for now and state the required return more formally.
Firstly, investors should be compensated for the real interest rate and inflation (note: the real rate plus inflation=nominal rate). This nominal rate is the rate of return on US Government bonds. Investors expect at least this when they buy a stock. The reason? A stock has risk and government bonds don't. If stock do not outperform bonds then investors will prefer the bonds. The second component of required return is inflation which is already incorporated into our nominal rate.
Lastly we have a premium for risk. Since investors do not know for sure if their investment will make them money, they want to be compensated for this additional risk with additional return. Again, we will look into these concepts in more detail later.
Risk
So how do you quantify this risk we spoke of earlier? Well there are basically two ways. The first is that risk is a function of the business, financial, liquidity, foreign exchange, and political risk of the firm. Business risk is due to the firms operating environment or the economics of its business. Financial risk is due to the firms choice of debt/equity mix. Liquidity is not a big problem for larger companies but for "micro caps" it can be a significant risk. Finally, political and foreign exchange risk would come into play if you decide to invest in international securities.
The second way to measure risk is using Modern Portfolio Theory and a statistic called the beta. Very simply, beta is a securities market risk or undiversifiable risk. A stock with a beta of 1.5 is 1.5 times more risky than the overall market.
Lesson 2: How to measure risk?
Now that we have our definition of an investment we must ask, "how do we value the investment in order to arrive at a fair price for it? " Throughout the rest of this lesson, we will give you the tools necessary to compute value in order for you to compare value to the current market price. Essentially, that is all there is to investing. If your estimate of value is greater than market price, the investment is a buy. If market price is above value, the investment is a sell (if you were really confident of your analysis you would even sell short, more on this later).
[an error occurred while processing this directive]