We recently talked about the advantage of ranking all of your investments based on three characteristics (expected return, risk and liquidity). In this article we will focus your attention on evaluating the attractiveness of an investment’s return. Have you thought about how to determine the return you require on an investment?
How to Determine the Return to Demand on an Investment
As you know, there are different levels of return expected for an investment. We also know that, as a rule, there is a close relationship between risk and expected return.
In fact, financial theory classifies investors as “risk averse”, meaning that for the same level of risk they want the maximum expected return. In other words, for a certain expected return, they will want to incur the lowest possible risk.
Although this premise makes sense in theoretical terms, we know that the reality is very different and that there are investors who are content with low levels of return for high risks. How do you know, then, what level of return to require for a given investment?
There Are Assets Without Risk
You may have heard of the Government Obligations (very fashionable theme), we have referred to the Portuguese Treasury Certificates. In fact, Government Obligations – are here the ebook on financial obligations – are considered the least risky investments of all, to the extent that the probability of governments failing to meet their responsibilities is very low. In fact, they are even called “Assets without Risk”.
Having these Bonds at a certain level of risk and return, and assuming as valid that we are all rational and risk averse, it is clear that we should not accept lower returns to the returns provided by these products, for the same maturity.
Set a Risk Risk Premium you are going to take
By talking about risky assets, it means that at this return (“risk-free asset”), we have to add some premium that compensates us for the additional risk we are incurring. In financial theory this is called the premium risk, directly dependent on the level of risk we incur (defined as Beta, whose development is outside the scope of this article).
What matters is that whenever you think about an investment and the return you want to get from that investment you will have to consider the minimum return level (“risk free asset”) and a risk premium. It’s simple. Do not forget this maxim because you have to be properly remunerated for the risk you incur.
Never forget that whoever invests must manage their risks and be compensated for taking those same risks. We suggest you to know our tips on how to invest for beginners here and never forget that in order to earn a consistent income, keep in mind that you must have a healthy family budget and that you must end some of your debts, such as debts of credit cards.