Evaluating the return of an
Raul Lopez /
Industrial Engineer MBA
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
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
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