TO INVEST IS TO TAKE RISKS. The higher the risks involved, usually the higher will be the return. The longer the period of the investment, the more volatile are the risks involved as well. Even investments that are likely to give a high return also carry the probability of very low returns or even losses.
This may be expressed as a probability: you may be 98 per cent sure that the investment will give a return of say five per cent. However, this means that there is a two per cent chance that the investment will not give a five per cent return. What if your investment falls into that slim area of poor or no returns?
Some people avoid taking risks as much as possible by placing their fund on long-term deposits in banks or buying government paper like bonds and debentures. Yet banks and governments have been known to fail resulting in lower than expected returns or even reductions in the principal amount invested.
Investment risks are wide and varied. For example, the market or overall national economy for the investment may take an unexpected turn for the worse; inflation may rise to the extent that it wipes out any real investment gains or even drive losses, and the business underlying the investment may falter and go bankrupt.
Ultimately, in order to beat inflation in the long term, investors tend to seek higher and higher returns on their investment according to their disposition to risks. Yet, some investors do not have a deep understanding of the risk/return of the particular investments and tend to rely on their personal banker, financial adviser or broker.
This review of the risks and returns sets the background for today’s scenario test. Which of the following investments will generate the greater fund balance?
1. Investing $2 000 and getting six per cent in the first year and four per cent in the second year?
2. Investing $2 000 at compound interest of five per cent over a two-year period?
3. Investing $2 000 and getting a 100 per cent return in Year 1; 50 per cent decline in Year 2?
4. Investing $2 000 and having its value decline six per cent in Year 1 and increase by ten per cent in the second year?
The largest ending fund balance after two years is Option 2. The steady effect of interest earning interest in the compound interest option generates a fund balance of $2 205, just $5 ahead of option 1.
Option 3 may look very attractive where you double your money in the first year, and the decline in Year 2 is only 50 per cent. However, when you work this out, by the end of the two years, you are back where you started with a fund balance of $2 000.
Option 4 presents a situation which starts with a decline in the first year, then growth and a higher rate in the second year. The end result is a fund balance of $2 068.
So the rank of these options presented in terms of the size of the fund balances is first Option 2; second Option 1; third Option 4 and last Option 3.
The computation of these fund balances can be done readily with a simple hand-held calculator. However, as you consider investments over a longer period, you will need to draw on the compound interest and annuity tables online.
The key point is that you feel comfortable computing a fund no matter how varied the earnings rate.
These scenarios are presented as a precursor to considering a retirement saving and investment scenario in order to test your understanding of the time value of money along with the risk factors involved in investing.
• Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. She can be contacted at louisefairsave@nationnews.com.
