Evaluating an investment
Evaluating investment opportunities (e.g. shares, property, bonds) is easier if you use a standard set of criteria to measure and compare them. While each investment must be evaluated in the context of your personal goals and objectives, in most cases the following characteristics may be considered:
- Return on investment (ROI)
- Minimum investment amount
- Ease of investment
- Taxation
Return on investment will usually be in the form of income (a payment you receive from your investment) or capital growth (where the value of your investment increases over time). Some investments, such as shares, may provide both.
Investment income may include amounts such as interest on bank accounts, dividends from shares, rent from a property and distributions from a trust. As well as the amount of income you are likely to receive, you should consider the likely frequency and regularity of the income payments and the potential for any increases or bonuses. Does the investment pay distributions, weekly, fortnightly, monthly or yearly?
Income from investments is usually subject to income tax at your marginal tax rate.
Frequency of income payments
The frequency of income payments is a key factor in determining the yield for an investment.
Compare three investments of $100,000 each with a 6% interest rate: the first paying annual coupons, the second paying semi-annual coupons and the third paying quarterly coupons.
Even though you receive coupons totalling $6,000 over the year from each investment, when you take into account the timing of the coupon payments the yield can vary. This is because the sooner you receive your income payments the sooner you are able to reinvest that money.
This means that the yield for an investment paying 6% quarterly may be higher than the yield for one paying 6% annually.
Capital growth generally refers to the increase in the value of the amount of money you have invested.
Returns from capital growth can only be realised when you sell an investment for more than its purchase price.
The main benefit of capital growth is that it protects you against inflation. This occurs when the value of your investment grows at a rate faster than the general rise in the price of goods and services. By keeping your capital growth ahead of inflation you are able to prevent inflation from eroding the spending power of your savings.
Capital growth may occur through rising share and unit trust prices on the sharemarket, increased values in the property market and profit on fixed-interest securities if sold before maturity. In Australia, realised capital growth from investments is usually subject to capital gains tax.
Comparing risk and return
Setting realistic expectations is important when determining what level of return you might expect from your investment.
When evaluating the return on investments you may wish to compare their rate against the return on government bonds. This rate of return is often called the 'risk free rate'. An investment in government bonds is generally very secure as there is little chance that the lender (the government) would default and fail to repay the investment.
The risk free rate may be a good guide to use when considering whether the risk is commensurate with the reward of an investment.
You can generally find the government bond rate in the business section of the newspaper.
This article is based on the ASX Share Course. November 2008.
This article is based on the ASX Share Course. November 2008.
