There is but a single reason to make an investment: to obtain a positive return. One indicator of return is an investment’s alpha statistic, which quantifies the difference between an investment’s expected return and its actual recent performance (outperforming or underperforming) given its risk. A stock or mutual fund with a positive alpha means the company did better than expected for its level of risk; a negative alpha indicates poor performance. Alphas for individual stocks, mutual funds, and other investments are available online through brokerage firms and advisory services. Alphas are an important statistic, but they are based on past performance and, thus, provide only a guide for future performance.
While you cannot know the exact performance of any investment in advance, you certainly will want to pay no more than the “right price” for the investment given its potential rate of return. Calculating returns on a potential investment involves five steps. Armed with these data, you will be better positioned to make informed decisions:
1. Use beta to estimate the level of risk of the investment.
2. Estimate the market risk.
3. Calculate the required rate of return.
4. Calculate the potential rate of return on the investment.
5. Compare the required rate of return with the potential rate of return on the investment.
Use Beta to Estimate the Risk of the Investment
Beta is a useful piece of information when you want to estimate the rate of return you require on an investment in a stock, bond, or mutual fund before putting your money at risk. Betas for individual stocks, mutual funds, and other investments are available online from brokerage firms, advisory services, and investment magazines. The following example illustrates how to use beta to estimate the amount of risk in an investment portfolio. Assume you are willing to accept more risk than the general investor and that you buy a stock with a beta of 1.5. If the average price of all stocks rises by 20 percent over time, the price of the stock you chose might rise by 30 percent, which is the beta of 1.5 multiplied by the increase in the market (1.5 20%). If the average price of all stocks drops in value by 10 percent, the price of the stock you chose might drop by 15 percent (1.5 ]x 10%).
Estimate the Market Risk
To estimate the required rate of return on an investment, you need to quantify the market risk. Market risk, also known as systematic risk, is the risk associated with the effects of the overall economy on securities markets. It often causes the market price of a particular stock or bond to change, even though nothing has changed in the fundamental values underlying that security. Historical records indicate that 8 percent represents a realistic estimate of market risk for U.S. stocks.
Calculate Your Required Rate of Return
The return on short-term U.S. Treasury bills has historically exceeded the rate of inflation by a slight degree. Thus, when T-bills pay 5 percent interest, the inflation rate might hover around 4 percent. This circumstance provides almost no gain for the investor. For this reason, investors often use the yield on Treasury bills as a base numberthat provides a zero real rate of return that is, a zero return on investment after inflation and income taxes.
To calculate your required rate of return on an investment, multiply the beta value of an investment by the estimated market risk and then add the risk-free T-bill rate, as shown in Equation (14.1). For current T-bill rates, seehttp://www.treasurydirect.gov/indiv/products/prod_tbills_glance.htm, and http://www.treasurydirect.gov/RI/OFBills. Use Equation (14.1) to determine an estimate of the required rate of return on an investment.
While you cannot know the exact performance of any investment in advance, you certainly will want to pay no more than the “right price” for the investment given its potential rate of return. Calculating returns on a potential investment involves five steps. Armed with these data, you will be better positioned to make informed decisions:
1. Use beta to estimate the level of risk of the investment.
2. Estimate the market risk.
3. Calculate the required rate of return.
4. Calculate the potential rate of return on the investment.
5. Compare the required rate of return with the potential rate of return on the investment.
Use Beta to Estimate the Risk of the Investment
Beta is a useful piece of information when you want to estimate the rate of return you require on an investment in a stock, bond, or mutual fund before putting your money at risk. Betas for individual stocks, mutual funds, and other investments are available online from brokerage firms, advisory services, and investment magazines. The following example illustrates how to use beta to estimate the amount of risk in an investment portfolio. Assume you are willing to accept more risk than the general investor and that you buy a stock with a beta of 1.5. If the average price of all stocks rises by 20 percent over time, the price of the stock you chose might rise by 30 percent, which is the beta of 1.5 multiplied by the increase in the market (1.5 20%). If the average price of all stocks drops in value by 10 percent, the price of the stock you chose might drop by 15 percent (1.5 ]x 10%).
Estimate the Market Risk
To estimate the required rate of return on an investment, you need to quantify the market risk. Market risk, also known as systematic risk, is the risk associated with the effects of the overall economy on securities markets. It often causes the market price of a particular stock or bond to change, even though nothing has changed in the fundamental values underlying that security. Historical records indicate that 8 percent represents a realistic estimate of market risk for U.S. stocks.
Calculate Your Required Rate of Return
The return on short-term U.S. Treasury bills has historically exceeded the rate of inflation by a slight degree. Thus, when T-bills pay 5 percent interest, the inflation rate might hover around 4 percent. This circumstance provides almost no gain for the investor. For this reason, investors often use the yield on Treasury bills as a base numberthat provides a zero real rate of return that is, a zero return on investment after inflation and income taxes.
To calculate your required rate of return on an investment, multiply the beta value of an investment by the estimated market risk and then add the risk-free T-bill rate, as shown in Equation (14.1). For current T-bill rates, seehttp://www.treasurydirect.gov/indiv/products/prod_tbills_glance.htm, and http://www.treasurydirect.gov/RI/OFBills. Use Equation (14.1) to determine an estimate of the required rate of return on an investment.
For example, assume you are considering investing in Running Paws Cat Food Company, which has a beta of 1.5. If you assume a market risk of 8 percent and the current T-bill rate is 2.0 percent, the total rate of return you will require on this investment is 14.0 percent [2.0 + (1.5 x 8.0)]. Investors need the promise of a return higher than 14 percent to put their money at risk in this investment.
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