Measuring Risks & Returns on Investments

Investing covers a wide range of activities; people can invest their money in various types of investment ranging from fixed deposits and stocks (which are fairly liquid assets), to property and gold (which are less liquid). Investing also encompass taking very conservative positions to aggressive speculation.

In general, investment involves the commitment of funds to assets that will be held over a long period of time. Investors (as opposed to speculators) would normally have time horizons that extend beyond a period of six months or a year.

In making the decision to commit their funds for such a long period of time, they would wish to derive a reasonable return on their investments. The return that they can earn from investing in the various types of assets including stocks, bonds, derivative securities, property and others, is known as the rate of return.

This return must compensate investors for-

1.opportunity costs of time - also known as time value of money,

2.expected inflation (which may erode their purchasing power in the future), and

3.the uncertainty or risk associated with the investments.

Why do investors invest? The simple answer to that is to make more money, that is to take the pool of money that they have, and to make it grow in value. In order to achieve this, investors must have a clear understanding of the investment process, the basics of making investment decisions and also an appreciation for the basic techniques involved in analysing investments.

The investment decision-making process involves taking into account the basic nature of investment decisions. How do investors decide whether to invest or not in a particular investment?

Shares have produced on average, significantly higher returns over the years compared to fixed deposits or bonds. But, should investors invest all their money in shares in order to realise higher returns? Or should they diversify and invest in other assets such as bonds and derivatives?

The answer to this lies in the fact that, in order to realise higher returns, investors must bear higher levels of risk. Therefore, underlying all investment decisions is the tradeoff between risk and return - the higher the risk, the higher the return. As such, in deciding on investments, investors should consider the risk and return involved.