how can you tell which of two options is better?
Dealing with Difficult People
8. Making sense of risk and return.
Out of all the MBA subjects I did, the one that I found least familiar was Corporate Finance - I don't have a background in finance or accounting, and it was the subject I did entirely online, during a season of bereavement. So reading back over the notes for this subject takes a little more time than with other subjects.
One of the key concepts from Corporate Finance was CAPM - the capital asset pricing model. This technique helps determine the relationship between risk and return on a given investment, so that a group of potential investments can be compared and evaluated. There is more than straight risk/return in creating a balanced investment portfolio - it's important to choose investments that have minimum dependencies on each others' operation, so that an incident that impacts one area of the economy does not impact a whole portfolio. If you have bought a stake in fuel, petrol stations, and cars, and then people stop driving for a period of time, then all those investments are impacted by the same incident, so your portfolio is not as balanced as it could be.
When you have some money to invest, and you're comparing one investment with another, the issue is built around FOMO. What could that money have done if it wasn't invested here? If there is a higher level of risk, then there needs to be a higher level of return, to compensate the investor for the risk they're taking on. To work this out, you can look at the average return (past results) and the expected return (future results, so estimated rather than documented).
We looked at Graham, Smart, Adam & Gunasingham Introduction to Corporate Finance chapter 7 as one of the readings, (a new edition has come out since the readings were set) to learn about the way that risk and return are measured for different investments. If you plot the monthly returns of an investment as it relates to the returns of a diversified set of investments (eg the ASX 200), then plot the gradient of that line, the gradient is called the beta of the investment. Combining the beta of different investments will let you determine the beta of the portfolio.
CAPM isn't perfect; it assumes that the real world is better informed than it really is, and that the cost of acquiring or disposing of an investment is nil, and it's based on expected returns, which need to be estimated, rather than on past returns which are known.
To go into more detail would require more maths than I'm aiming to include in this newsletter, but it's helpful to be aware that the CAPM model exists, so you can think of different investments in a similar way, and asses which one you want to proceed with, based on your acceptable level of risk.
I don't think I'm straying into the territory of financial advice in anything here, but of course nothing I'm writing is intended to be financial advice, just providing you with information on a widely known model for comparing possible investments.
Have you heard of CAPM before? Hit reply and let me know!
Dave.
Work. Study. Dad.