When weighing options, compare like with like
Posted Saturday, August 18 2012 at 01:00
- Often, we fail to consider the time and simply look at the investment return.
A very interesting response from a reader regarding my calculation of investment returns was published a few weeks back.
In one of my previous articles, I had used the following example: If you buy shares for Sh100 000 and next year you sell them for Sh150 000, your return is Sh50 000.
In percentage terms, you have made a return of 50 per cent (Sh50 000/Sh100 000).
This particular reader’s argument was that the return was 33.3 per cent, ie (Sh50 000/Sh150 000). The mistake he made, and indeed many of us make it when calculating investment returns, was to include the actual profit in the calculation.
By using Sh150 000, he added the original Sh100 000 invested to the Sh50 000 made. This is wrong. Investment returns are always calculated based on only the principal amount invested, ie the original amount invested.
The basic motivation for any investment is to earn money over and above the original amount. When comparing different investments, you want to know which one earns you more money above your initial investment amount.
The cost of debt
If you had Sh100 000 and you were presented with two options, one earning 10 per cent per annum and the other 20 per cent per annum, it means that you could earn Sh10 000 or Sh20 000 within the same period.
When using debt for investments, always consider what that debt cost you to calculate your true return. Say you borrowed Sh100 000 to invest, over the course of the year spent Sh20 000 in interest charges then sold your investment for Sh150 000. Your true return in this case is Sh30 000 (150,000 -120,000).
It is also very important to compare investment returns based on time. You could be presented with a higher return in one option but which requires a longer time to realise.
For example, on the same Sh100,000, you may be told that you can earn 15 per cent per year or 25 per cent in two years.
Many times we forget to take into consideration the time and simply look at the return. It is always important to compare returns over the same period of time.
A 25 per cent return does sound more appealing than 15 per cent but to actually know what makes sense for you, it is important to calculate what the return would be in a single year.
This is what is referred to as annualised returns. In two years, the investment option giving 25 per cent will give us Sh25 000. This is equivalent to Sh12 500 per year.
The annual return on this investment is therefore 12.5 per cent. In the same year, the investment option giving 15 per cent will give us Sh15 000. This option therefore has a higher annual return.
I have often heard people talk about investments doubling, but often, doubling takes a long time and the investors forget other factors that were a cost in that investment.
There are other factors, not just returns, to take into consideration when investing, such as risk and time. However, knowing and understanding returns and then being able to compare two choices is a key component of investments.