Question

Please explain the purpose of the investment in our life? Which factors are important for giving the correct investment decision? Also explain the necessary formulas to calculate the required rate of return. Please show the effect inflation and real rate of return.

Answer 1

Basic Purpose of investments for a rational investor is to earn returns by taking a reasonable level of risk. Investors put their saved money in high yielding investments so that they can meet their short term, medium term and long term financial goals.

Factors to consider while taking investment decisions:

1. Financial roadmap including various financial goals and investment horizons

2. Risk tolerance levels of the investor should be taken into account before investing

3. Appropriate mix of investments; asset allocation including risky and risk free assets in the portfolio to hedge losses.

4. Maintaining an emergency fund at all times to take care of the rainy days

5. Rebalance the portfolio occassionally to ensure that you earn the required return by taking minimal risk

Required rate of Return on equity investments (CAPM):

Required return= risk free rate + (Market return- risk free rate) * beta of stock

Required return on overall investment= (Appreciation in portfolio value + dividend or interest received)/

Initial investment in portfolio

Inflation erodes the value of investments over time and hence it motivates the investors to shift their funds to low inflation markets. Real rate of return is the return excluding effects of inflation, this return shows a much clear picture of what an investor is expected to earn under normal conditions.