Answer to Question #165201 in Economics for Mirza Dzakirin

Question

What is the relationship between financial decision-making and risk and return? Would all financial managers view risk-return trade-offs similarly? (600 words)

Answer 1

What drives most people to invest?

The desire to increase your capital, to provide yourself with a certain passive income that covers your needs, or to achieve goals that require funding.

At first glance, the fulfillment of all these desires of a person depends on only one cherished number - profitability.

Sometimes 20% per annum is not enough to achieve the goal, but 30% is already enough. Is it really necessary in this case to simply find instruments that offer higher profitability?

Cryptocurrency funds promise 6000% per year, microfinance organizations - 20-30%, and banks - 6-7%. The profitability of investments in stocks/bonds and various strategies in the advertising materials of brokers sometimes simply amazes the imagination, both in terms of their values ​​and their spread. A cautious investor chooses banks, greedy and risk-averse cryptocurrencies, and other instruments of dubious investment attractiveness.

Investment instruments can be divided into two categories:

1) Instruments with fixed income - the profitability of which is determined at the time of investment. At the same time, the profitability must be guaranteed by the party receiving the money, the terms of the contract, and the only reason for the change in profitability may be the insolvency of this party. The most common examples of such instruments are deposits, bonds, loans.

2) Other instruments - the profitability of which depends on one or a number of different factors. So, for example, the profitability of investments in stocks depends on a huge number of factors, some of which are subjective (emotional reactions of exchange players and other behavioral factors). The main type of such instruments is stocks.

Returns can also vary as follows:

In rubles or other currency. It is correct to calculate the profitability in the currency in which the investment was made. At the same time, if it is necessary to compare the profitability of investments in different currencies, the profitability must be brought into one currency using the appropriate exchange rates. It is incorrect to compare the profitability of deposits in rubles and dollars on the forehead;

Nominal and real. In order to estimate the real return on investment - the increase in welfare over the period - it is necessary to subtract inflation (inflation expectations) from the calculated (promised) return.

Clean and dirty. Typically, promotional materials focus the investor's attention on the return before various commissions and service charges. For a correct comparison of various instruments, it is necessary to compare their profitability minus the corresponding commissions and fees.

So, for a correct comparison, the returns must be pure, in the same currency, and also be either nominal or real at the same time.

Lack of real returns means no increase in wealth.

Now let's move on to another characteristic that is inextricably linked with profitability - risk.

Risk is what prevents an investor from sleeping soundly

If with regards to profitability, everything is basically clear, then most people have a very vague idea about the risks of investments. Meanwhile, the risk is an integral part of an investment. When a reasonable investor considers another idea, the first thing he thinks about is not profitability, but risk.

The main investment risk is the risk of partial or complete loss of invested capital.

There are a number of indicators to assess investment risks, but in many cases, it is not possible to measure the risk of investing in a particular instrument, let alone compare it with the risk of investing in another instrument.

For example, to assess the risk of investing money in MFOs that promise their investors 20% per annum, it is necessary to have information about the creditworthiness of the borrowers of this organization, but it is not provided to depositors. Thus, it is simply not possible to assess the risks of investing in an MFO.

General rule: in the absence of risk assessment (understanding the probability of capital loss), you should refuse to invest in this instrument.