When it comes to investing your money, you need to understand the relationship between risk and reward. When you assume the risk of investing in a stock, you anticipate a reward. The reward should be appropriate given the level of risk you are assuming.
However, the reward is just a potential. Due to the risk, there is no certainty.
You should still figure out what your reward should be on an investment. The good news is that it isn't difficult to see if the reward and risk are in line with each other.
Start by determining the "risk-free" return that is currently available on the market. This is the baseline for your reward measurement. Most investors use US Treasury Bonds as their benchmark - partly because governments aren't expected to default. For example, a risk-free return from a Treasury bond of 5% could be your baseline. Any investment that has risk must give you a better return than 5%.
The amount of return that you receive over your baseline of 5% is your risk premium. If you are looking at a stock with an expected return of 10%, you have a risk premium of 5% on that return.
Then you must decide if the premium is large enough for the risk associated with the particular stock. Keep in mind that the stock may not achieve the return you expect. It depends on the type of stock. Large-cap, well-established stocks are fairly solid bets. New small-cap stocks may have too much risk for the premium to justify them.
When it comes to the analysis you should perform on a stock before purchasing it, there are many tests that you should put the stock through. However, it is important to know whether or not the investment risk premium is worth the risk that the stock places on your portfolio.
You should also keep in mind that your rate of return on a stock is affected by inflation and taxes. When you calculate your rate of return, you must make sure that you are thorough in your calculation. What you are looking for is the real interest rate, not the nominal rate.
The nominal interest rate tells you the growth rate of your money. The real interest rate tells you how much your purchasing power is growing. Your money could increase without seeing an increase in your purchasing power.
For example, if your investment grows by 6% in one year and the rate of inflation for the year is 3%, your real rate of return is only 3% (6-3). If you are depending on dividend income or interest from bonds, you will be affected by the costs of inflations.
If you hold onto a stock, the gains can build. An $1,000 investment with a nominal rate of 8% can easily turn into a real rate of 2.6% after inflation and taxes. This is something to consider when planning your portfolio and investments.
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