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Evaluating the return of an investment instrument

ITIPress.org - Raul Lopez / Industrial Engineer MBA

When you invest in a company or a business, you trade present “sacrifices” with expectations of future (higher) benefits. You are projecting either a higher value of your invested assets  and/or interests and dividends

However, how can you compare the return of a particular investment instrument with other existing alternatives in the market?. You can analyze it by comparing market indices like the Dow Jones, S&P 500 (both on the NYSE), IPC in Mexico, BOVESPA in Sao Paulo or MerVal in Argentina. If you’re not even receiving a better return than the market indices as a percentage, your return is probably not the best. Why? If you had invested in a similar composition than the broad market, you would have had better returns at a minimum risk.

However, evaluating the projected return of an investment instrument is complicated, because one has to take into account uncertainty. To evaluate the adequate remuneration for uncertainty one needs to have a point of reference, which are usually government bonds which are considered risk-free.

For all other investments instruments there has to be a premium
on top of this risk free investment to make it worth investing. This premium will be a function of the return of the risk-free investment and the broader market. It increases or decreases in function of how this investment instrument is sensible to the movement of the broader market. This last concept is called beta of the investment instrument.

Knowing not only the returns of risk-free investments, of the broader market and the beta, the calculation of the necessary return is a simple arithmetic analysis. If the investment instrument was negotiated with a higher return than the calculated, it means that it is undervalued and vice versa, if it was negotiated with a lower return, it means that it was overvalued (and it’s price will go down).

Regretfully, it is not that easy to get all the necessary numbers. As time is a limited good, instead of spread-sheeting and realizing statistic calculations, it might be a good idea to appeal to financial specialists in order to obtain information or advice. Fortunately, there are many different alternatives for investing, from the traditional to the Internet sites which offer this type of information.

“The future is purchased by the present”. Dr. Samuel Johnson




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