You may be in a situation where you need to make an investment decision. You’ll already know that one of the worst possible ideas you can have is to keep it in a bank; you’ll see from a previous post here, that keeping your money in the bank will probably leave you worse-off.
With this spare money, you, as a savvy money person, in theory should be looking for opportunities to grow your money to make your money grow; this could either be to gather a return 40 years down the line, or to gather a return 2 years down the line. In any event, the ultimate objective is to grow money and make it work for you, resulting in the creation of value. The opposite is worse-off by not using it properly and being subject to forces like inflation and interest rates.
I must start with a disclaimer that most investment opportunities come with risk. The underlying principle of risk is that the more risk you are asked to take, the more you should be rewarded for it; that’s why Government bonds are so low yielding – this is mainly because of their low-risk nature, relative to a business deal or stock opportunity. Risk even comes with keeping money in your bank, but the low return on your money suggests that a bank is also low risk. This is a good article that describes the risk-reward relationship in more detail. It is to be noted that everything comes with risk and in this article, I assume you are assessing risk relative to your risk appetite as required. If you’re not comfortable with an opportunity and it doesn’t “feel right”, then it’s too risky for you – simple!
So the three things to take into consideration when considering an investment opportunity are (in this order):
1. Return on Capital Employed
or “Return on Employed Capital”; “Return on Invested Capital”; “Return on Capital Invested”
The ROCE measure tells us what the percentage profit return is on the money we invest is i.e. the amount of profit a person makes as a percentage of their total money invested.
This is probably the most widely used measure used to determine an opportunity’s profitability. It takes in to consideration the income generated by the opportunity relative to the amount of money that is to be invested and presents this as a number in percentage terms.
What’s also important is that it is a percentage based measure; this allows us to compare the ROCE with other opportunities to see which is more profitable, irrespective of opportunity figures or size of investment. This is useful in the event you have two opportunities and don’t know which to invest in.
Ensure this figure beats your bank interest rate and inflation where possible. The higher this figure is, the better.
2. Time Value of Money
Okay, so with your ROCE measures in your hand from two opportunities (#1 & #2) for example, it’s now important to know how long it will take for your return from each opportunity to materialise. This is important because although ‘opportunity #1’ may offer an ROCE of 45% and ‘opportunity #2’, 30%, the time difference between these two opportunities may influence the investment decision.
Fathom this: ‘Opportunity #1’ will give you your initial investment + 45% return in 30 years and ‘opportunity #2’ a 30% ROCE in 10 years. Naturally, based on a quick back of envelope calculation, most people would go for ‘opportunity #2’ otherwise the investor may be waiting an extra 20 years for a further 15% return! Furthermore, if you break it down to a yearly basis, it would suggest ‘opportunity #2’ is more profitable across the project term, despite the lower ROCE! – this is why time period is important.
Anyway the real reason the measure of how long the opportunities will take to materialise a return is important is because (a) the longer it’s taking to get your money back, the more opportunities you may be missing to generate either an equal or higher return. Secondly, (b) as time progresses, the value of each pound tied up in both your initial investment and anticipated return is uncertain. The value of the pound may fluctuate and worst case, be worth less in the future than today – think of quantitative easing or inflation and these diminishing the value of the currency, therefore rendering that same pound less valuable in the future, not being able to buy the same amount of things as it can today. So the quicker the return, the better, because you can use money in your hands today, based on todays value to invest to either generate more money or buy more things instead of tomorrow’s uncertain value.
3. Opportunity Costs
And lastly, the opportunity cost. When investing in something, you’re tying money up in to something that you won’t have access to for a certain period of time, therefore where opportunities arise in that period and where the money is tied up, you won’t be able to capitalise on them because you don’t have the funds available, because they’re tied up! Or invested. So on this basis, it is always good practice to understand that, by investing in one of the two opportunities presented, what other opportunities you may be missing out on as a result. For example another opportunity, ‘opportunity #3’ for instance could be a lower returning opportunity that comes with less risk that might work in line with your investment objectives or risk appetite. It could even be similar return, but in a different project that you may know more about. In simple terms, it’s the consideration of any other opportunities that you will miss out on because the money is tied up elsewhere.
There are other things that could be taken in to consideration e.g. if the return is fixed or compound based or ensuring the level of reward is proportionate to the level of risk, but I think the above three measures enable any lay person to make a good, considered financial decision, enabling your money to make you richer.