Introduction
Many people invest blindly, without understanding what they are putting their money into or what to expect from the investment. Common scenarios include buying trendy assets that have already appreciated due to high returns or being lured into leveraged trading with promises of extraordinary yields, without comprehending the risks involved.
This, in my opinion, is the worst mistake when investing: not understanding where one’s money is going, failing to grasp the risks, and lacking clarity on potential outcomes.
In other words, before investing, one must understand what the investment is, how it functions, the expected return within their investment horizon, and the associated risk.
Understanding Expected Return and Risk
To intuitively grasp these concepts, let’s consider an example. Suppose we have 100,000 pesos and only two investment options:
- Lending to a neighbor, a high-ranking executive from a multinational company doing well financially but facing an emergency. He promises to return our money in six months when he receives his savings fund. In exchange for the loan, he offers a 10% interest rate during the period (annualized at 20%).
- Investing with the corner store owner, who received an opportunity to exclusively distribute an innovative product. To capitalize on this, he needs the money to bring in the product and start promotional activities. He promises a return in six months, guaranteeing our investment with assets from his store. If everything goes as planned, he’ll pay us interest at a 40% annual rate; however, there’s only a 50% chance of this happening. If things don’t go well, he’ll return the invested amount but won’t pay any interest.
In both scenarios, the investment horizon is six months. Although not immediately obvious, the expected return is similar. However, the risk levels are vastly different.
Calculating Expected Return
To calculate expected return, each possible scenario has an associated return and a probability of occurrence. Generally, the expected return is the sum of potential returns multiplied by their probabilities.
In option 1, there’s only one possible scenario with a 100% probability. The annualized expected return is 20%.
For option 2, there’s a 50% chance of earning a 40% annual return. Calculating this, we get (50% x 40%) = 20%. Simultaneously, there’s a 50% chance of earning nothing (50% x 0%) = 0%. The sum of these products results in an expected return of 20%, similar to option 1.
However, the uncertainty is significantly higher in option 2, which is precisely what we call risk in an investment: the variability of expected returns or, as sometimes stated, volatility.
Choosing the Best Investment Option
Given the same expected return, it’s clear that option 1 is better due to its lower risk. However, if the corner store owner increases the return to 50% annually, the decision becomes less obvious. The expected return now becomes 25%, with a 50% chance of earning 50% annually and a 50% chance of earning nothing.
Some individuals prefer lower returns with higher certainty, while others opt for the possibility of higher gains despite the risk of losing everything. This is known as risk tolerance.
If one has 200,000 pesos to invest, they could allocate funds to both options. With the improved offer from the corner store owner, the expected return would be 22.5% annually. The risk of this “portfolio” is higher than investing solely in option 1 but lower than investing only in option 2, illustrating the benefits of diversification and its impact on risk reduction when done purposefully and intelligently.
Conclusion
This example is simplified but effectively demonstrates crucial investment concepts: investment horizon, expected return, and risk. In the next part, we’ll discuss determining expected return and investment risk in financial markets.
Key Questions and Answers
- What is the importance of understanding expected return and investment risk? – It’s crucial to comprehend what you’re investing in, the expected return, and associated risks before making an investment.
- How do you calculate expected return? – Expected return is the sum of potential returns multiplied by their probabilities.
- What is risk in an investment? – Risk refers to the variability or volatility of expected returns.
- What is risk tolerance? – Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand.
- How does diversification affect investment risk? – Diversification can reduce overall portfolio risk when done strategically and intelligently.
