If you are a new student embarking on the mutual funds or securities course, or maybe you are an investor that wants to know a little bit more about investing. If you’ve checked out the channel, you may have noticed that we offer a 17 video playlist called ‘Investment Basics’. In that series, we have a video called ‘The Risk Reward Relationship’, where we talk about the fact that to achieve a higher return, one is generally assuming more risk. So what if you were presented with an investment that has an expected return of 6% and a riskier investment that has an expected return of 7%? What does that mean? Well, obviously a difference of 1%. But, so what? It is easier to appreciate if we talk in terms of dollars and time.
Let’s look at an example.
Hannah is saving for retirement and has decided to contribute $10,000 at the end of each year for the next 30 years. She is considering a portfolio with an expected return of 6% versus a portfolio with an expected return of 7%.
Let’s pull out my handy dandy financial calculator and do some calculations. Now in this video, I’m not going to go through the specifics of using the calculator, adjusting the settings, etc. But if you want to learn how to do this easily, check out the video in that series called ‘The Time Value of Money’, where one of my colleagues does a great job of breaking it down for you. In that video, he suggests using a template for these types of questions, which you will now see [in the video].
Let’s start with an expected return of 6%. The N is 30 because she’ll be saving for 30 years. The I/YR will be 6, which is the expected return on her investment. The present value (PV) will be 0 because Hannah hasn’t saved anything yet. The payment (PMT) will be -$10,000 because that’s how much she’s going to be taking out of her pocket or bank account each year and putting into her investment pool.
Future value is unknown, right? That’s what we’re trying to determine. On the calculator, if we press the FV button, we get an answer approximately $790,582. Now, what if Hannah selects the riskier investment and it generates the expected return of 7%. This is what I really love about this calculator because I don’t have to re-enter everything. All I need to do is change the one variable. I enter 7, then I/YR, and then press FV, and arrive at an answer of approximately $944,608. That’s a pretty big difference!
Just for fun, I’m going to plug in 8% and see how that would impact the answer. 8, I/YR, FV. We get an answer of approximately $1,132,832. Now in this scenario, we can see that an extra 2% return would generate approximately an additional $342,250 over 30 years. That doesn’t mean you should always pick the investment with the highest expected return. Keep in mind that risk and reward are interrelated, and there’s a lot more to consider. Also, the expected return is by no means a guarantee of the actual return.
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