Join Rudolph Rosenberg for an in-depth discussion in this video What makes a good investment?, part of Making Investment Decisions.
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A good investment is much more than just getting a positive return on an investment. If, for example, you invest $100,000 for ten years and get $100,001 in return at the end of that period of time. I bet you will question whether that investment made sense in the first place. And you know what? I'm completely there with you. Investing $100,000 is a very signifigant amount of money. And it is not worth your while to invest it on a project, that produces a single dollar of return over the course of ten years.
The first reason why we intuitively understand that this is not a good investment, is because we know we could have made much more money by investing it somewhere else. And that, is the first additional criteria to making a good investment decision. To make a good investment, we must compare the investment opportunity to other comparable opportunities. To make sure we put our money in the right place. As a simple example, anyone can have a saving account. And usually, the interest rate on those accounts range from 1% to 2% per year.
And sometimes a bit more. Let's assume here, our saving account generates 2% interest per year. By putting our money on a saving account, we know for sure we will be making a 2% return per year. Knowing that, why would we want to take on a project that yields anything less than that? Another aspect of making an investment decision, is the level of risk associated with the project to be undertaken. Not all projects yield a positive return. In many projects have a potential to make you lose money.
Buying stocks for example, on the stock exchange holds no guarantee of seeing any money back. So if for example, you had an opportunity to invest your money on a project yielding a 2% return per year, with some level of risk. Why would you invest in it, when you know you have a risk free option with a saving account for 2% return per year as well? I would not invest in such a project, and neither would you. By the way, let's add here a new keyword to our list. Risk.
Taking on a riskier project should yield a higher return, to compensate you for the risk you are taking. At the end, it sounds logical. Safer bets yield less return then riskier ones. The last criterion to making an informed investment decision is related to the pace at which you will be getting the return. Will it be the same amount every year? Will it be increasing over time? Or will you be getting it all at the end? When you get the return from the project, is going to have an impact on the overall return of your project.
We will see in the later chapter, why the faster you get the return and the more attractive the investment would be. To summarize, when comparing projects, the return in itself is insufficient to determine if it's a good or bad investment decision. The elements to be considered are, does the project have a positive return on investment? What are all the investment opportunities available to you, and what return do they yield? What level of risk are you comfortable with? Is the return sufficient to compensate you for the risk you are taking? And at what pace will you be getting the return? Making the difference between an investment opportunity that is suitable to you, and one that is not, will require a financial methodology that you will learn in the next chapter, called the Net Present Value.
Or NPV. As well as applying personal judgment on the strategy of the project. Both are essential to selecting projects that will meet your return expectations.
This course teaches the net present value (NPV) methodology, an investment evaluation formula used by countless publicly traded companies and financial analysts, in a way that makes it accessible and applicable to you—no finance background required. Rudolph Rosenberg explains what investments are, how they are measured, and what makes a good investment. Then he explores the NPV formula in depth, showing you how to evaluate your cash flows, choose a rate of return, and assess the risk of a particular investment. This all culminates in a look at how the principles of investment apply to three real-life scenarios that any individual or company might encounter.
- What is an investment?
- Understanding ROI
- What makes a good investment?
- Using the NPV formula
- Assessing risk
- Applying NPV to real-life situations