In recent years we have seen in Portugal and in the World several situations that led us to conclude that there are not many risk-free investments. Several people were confronted with mockery and fraud that could have been avoided if a proper assessment of the risk and expected return of that investment had been made. Thus, in this article we will try to show how to define the return it should require to invest in a given financial product.
More Returns Involve More Risk
In financial markets we say that investors are rational and risk averse. Being two assumptions that often do not occur are true if we consider the average of the investors. And this means that:
- We want to minimize the risk of two products with the same return;
- We want to earn more than we earn less.
Unfortunately, we often forget the immediate relationship between risk and return. And we forget to demand compensation for the increased risk that we will assume. Incidentally, this is easily visible when we look at term deposits and compare them with other products like savings certificates. Entering into other types of products is also visible when we decide to “invest” in financial obligations of football clubs (which are typically “bankrupt”) and do not require the higher rate of return.
Know the Minimum Return on Demand for your Money
There is a minimum of return to demand for the use of our money. And this minimum is something objective because there are financial assets that are typically assessed as “risk-free.” For example, if we can earn close to 1% when investing in savings certificates, why should we make deposits with lower rates?
The Risk Prize is now missing.
Once we know the minimum return value, which is visible in the financial investments perceived as the lowest possible level of risk, it is enough to add to this rate of return to premium that will be proportional to the level of risk that we assume. For example:
- Investment in Corporate Bonds – 2%
- Investment in Shares – 5%
Thus, the sum of this rate of return with the required minimum rate of return will allow us to approximate the minimum we can expect by investing in corporate bonds or equities in this case.
This discussion may seem theoretical but has a great practical application. It obliges us to be demanding with our account managers and the products that we are offered. Never forget that your account manager is looking for commissions and reaching certain business goals so you have to be the customer looking for information, asking questions and deciding what is best for you. Otherwise, we may have the repetition of dramatic situations such as those experienced in recent times .