Return on Investment : Mistakes to avoid

Hi Folks !

I have come across many times that, lot of people (educated & uneducated and even people with finance back ground - this is the motivation behind writing this article) in society get so much awfully surprised by word “returns on investment” and completely get carried away with out putting return on investment in context. I have one real example to share with you; (many of you already do it in right way- Great! & help spread awareness to those who don’t)

One of my relative came to me one day & said, “you know what! I earned cool 30% on particular investment!”  Another cousin seating next to me was like wow! Tell me I also want to invest.

A classic example of taking return of investment without any context & jump into investing.

What is missing in above statement “I earned 30% on particular investment”? From my perspective two things at the least; (there can be many more specially inflation-adjusted returns but these two comparison bench marks are never going to go away) 1.Time period 2. Risk involved.

Let me just ask you one simple question if your friend comes to you & say, “ I earned 40% returns on asset-A & I earned just 14% on asset –B, isn’t asset-A great asset?”  What is your answer?

My answer is I can not say whether asset-A is better as compared to asset-B, before I know in what time period return is generated & what was risk involved. The key point is with out knowing how long (time period) the investment was made & what was the risk in it, no body can ever say it is good or bad investment.

 Next time whoever you are facing, be it elder person from your family, friend, investment/mutual fund professionals, your professor etc. with the above question or asking you to invest with high return on investment asset check out on Time period & Risk involved first.

 In general terms here, risk means volatility or movement in the price of asset in particular time frame. So, in simple words, higher the volatility higher the risk. (Risk/volatility stuff is ugly for getting into details so I am just sticking to basic understanding here)

Now let me add in the above statement, “I earned 40% returns on asset-A & I earned just 14% on asset –B. I got 40% on asset-A after 8 years with 56% annual volatility(risk), while I got 14% on asset-B in 2 years with 5% annual volatility(risk).” Now what is your answer- which asset is better?

Let’s do bit of Maths;

1. To compare different time period assets we have to calculate annualized rate of return. So that we can compare on same time-scale.
2. To compare different risk-involved assets, we divide time adjusted rate of returns by volatility (risk). So, that we can compare on same risk-scale.

Asset-A

Annualized rate of return for 40% return over 8 year is 4.3%.( {(1+0.4)^ (1/8)}-1*100=4.3%)

So, effective after risk-adjusted rate of return (for taking 1% of risk you get this much % of returns) = 4.3 % / 56% = 0.076%

Asset-B

Annualized rate of return for 14% return over 2 year is 6.77 %.( {(1+0.14)^ (1/2)}-1*100=6.77%)

So, effective after risk-adjusted rate of return (for taking 1 % of risk you get this much % of returns) =  6.77 % / 5% = 1.35%

So, now when you compare for time period adjusted (as time period is different in both assets) & risk adjusted returns of assets A & asset-B, certainly asset-B is better as you get 1.35% return with compare to 0.076% return of asset-A, in the above context.

Friends! You are the king now. Never take returns on investment in absolute way from any one. We all make investments in different ways & in different phases of life, so next time any one says this is cool investment due to whatever return on investment, straight away ask for time period & risk involved in it or better calculate yourself the time & risk adjusted return & then only decide or make comment.

Hope by better thinking/understanding on the above stuff we can make our day to day life bit better!

Feel free to share any suggestion/question/doubt. Thanks!