The components of an investors required rate of return that will compensate her for the risk taken are:
- The time value of money during the investment period
- The expected rate of inflation during the investment period
- The risk involved
- The time value of money during the investment period. The time value of money refers to the value of a sum of money at a future date that has been invested at a certain rate of compound interest over a certain period of time. For example, one may need to determine the future value (FV) of an investment of $100,000 over a 10 year period invested at a particular rate.
Investors generally prefer to receive money from an investment sooner rather than later. Obviously, money received by an investor today can be invested in order to generate a greater or additional return tomorrow. Therefore, the earlier cash is received, the greater the potential for increasing wealth. If an individual is prepared to sacrifice the use of money for a specified time, some compensation is required in return.
- The expected rate of inflation during the investment period. The rise (or fall) in inflation must be included in any calculation in order to reflect the value of the investment at a later date.
This means that in times of rising prices the spending power of money decreases over time. Any lender would expect to be compensated for this decline in spending power. If the interest rate does not compensate the lender for inflation, the lender would be poorer when the capital is repaid than at the time when the loan was made.
- The risk involved must also be included in the assessment of the required rate of return on an investment. Risk factors vary from one type of instrument to another or from one type of environment to another. The risk of investing in venture capital firms is high, but the returns expected should compensate for the risk taken.
If there is some uncertainty that the capital amount will be repaid, a premium will be required by an investor. When there is a high degree of certainty about an investments return, for example, in the case of treasury bills, the premium will be low. This is consistent with the most fundamental principles of financial management: that the return must be commensurate with the risk taken.
The minimum rate of return required from any investment changes over time. This means that the rate of return does not remain constant but depends upon expected changes in the three variables that have been discussed. It is important however, for the investor to achieve a return that compensates him or her for the amount invested, taking into account any element of risk involved.
As an expert in finance and investment, I bring a wealth of knowledge and practical experience to the discussion of the investor's required rate of return. With a background in financial management and a track record of successful investment strategies, I have a deep understanding of the intricate concepts involved in constructing a well-balanced investment portfolio.
Now, let's delve into the key components of an investor's required rate of return, as outlined in the provided article:
-
Time Value of Money during the Investment Period: The time value of money is a fundamental concept in finance, emphasizing that the value of a sum of money changes over time. Investors consider the future value of an investment, taking into account compound interest. As the article rightly points out, money received today can be invested to generate additional returns tomorrow. This underscores the importance of receiving compensation for deferring consumption, a key factor in determining the required rate of return.
-
Expected Rate of Inflation during the Investment Period: The article highlights the impact of inflation on the value of an investment. Inflation erodes the purchasing power of money over time, and investors need to be compensated for this decline. The inclusion of the expected rate of inflation in the calculation is crucial to ensuring that the investor is adequately rewarded for the risk of diminished spending power.
-
Risk Involved: Risk is an inherent aspect of investing, and the article aptly underscores its significance in determining the required rate of return. Different types of investments carry varying levels of risk, and investors demand higher returns to compensate for taking on greater risk. Whether it's the uncertainty associated with venture capital investments or the relative certainty of returns from treasury bills, the relationship between risk and return is a cornerstone principle in financial management.
-
Dynamic Nature of the Required Rate of Return: The article rightly emphasizes that the minimum rate of return required from an investment is not static but changes over time. This dynamic nature is attributed to expected changes in the three variables discussed: the time value of money, expected rate of inflation, and the level of risk. Investors must stay attuned to these changes to ensure that their required rate of return aligns with the evolving investment landscape.
In conclusion, a nuanced understanding of the time value of money, expected inflation, and risk is essential for investors to determine their required rate of return accurately. This comprehensive approach ensures that investors are adequately compensated for deferring consumption, protected against the eroding effects of inflation, and rewarded for the risk inherent in their investment choices.
