Page 70 - DMGT515_PERSONAL_FINANCIAL_PLANNING

Unit 4: Measuring Investment Return

Commodities: The items that are traded on the commodities market are agricultural and industrial Notes
commodities. These items need to be standardized and must be in a basic, raw and unprocessed
state. The trading of commodities is associated with high risk and high reward. Trading in
commodity futures requires specialized knowledge and in-depth analysis.
Real estate: This investment involves a long-term commitment of funds and gains that are
generated through rental or lease income as well as capital appreciation. This includes investments
into residential or commercial properties.

4.3 Expected Return of an Asset

Risk and expected return are the two key determinants of an investment decision. Risk, in
simple terms, is associated with the variability of the rates of return from an investment; how
much do individual outcomes deviate from the expected value? Statistically, risk is measured by
any one of the measures of dispersion such as co-efficient of range, variance, standard deviation
etc.
The risk involved in investment depends on various factors such as:
The length of the maturity period – longer maturity periods impart greater risk to
investments.
The credit-worthiness of the issuer of securities – the ability of the borrower to make
periodical interest payments and pay back the principal amount will impart safety to the
investment and this reduces risk.

The nature of the instrument or security also determines the risk. Generally, government
securities and fixed deposits with banks tend to be riskless or least risky; corporate debt
instruments like debentures tend to be riskier than government bonds and ownership
instruments like equity shares tend to be the riskiest. The relative ranking of instruments
by risk is once again connected to the safety of the investment.

Equity shares are considered to be the most risky investment on account of the variability
of the rates of returns and also because the residual risk of bankruptcy has to be borne by
the equity holders.

The liquidity of an investment also determines the risk involved in that investment.
Liquidity of an asset refers to its quick salability without a loss or with a minimum of loss.

In addition to the aforesaid factors, there are also various others such as the economic,
industry and firm specific factors that affect the risk an investment.
Another major factor determining the investment decision is the rate of return expected by the
investor. The rate of return expected by the investor consists of the yield and capital appreciation.

Real and Nominal Rate of Return

We have noted earlier that an investment is a postponed consumption. Postponement of
consumption is synonymous with the concept of ‘time preference for money’. Other things
remaining the same, individuals prefer current consumption to future consumption. Therefore,
in order to induce individuals to postpone current consumption they have to be paid certain
compensation, which is the time preference for consumption. The compensation paid should be
a positive real rate of return. The real rate of return is generally equal to the rate of return
expected by an investor from a risk-free capital asset assuming a world without inflation.
However, in real life, inflation is a common feature of a capitalist economy. If the investor is not
compensated for the effects of inflation, the real rate of return may turn out to be either zero or

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