Definition and objective of investment
The term investments refers to a portfolio of assets purchased with available funds that provides a return in the form of periodic cash flows and/or a gain (or loss) in the amount of the original amount invested (the capital). This tells us that there are two parts (either or both) to a return on an investment:
- a periodic cash flow
- a change in the value of the original investment (capital value), which may be positive or negative.
Flowing from this, the objective of investment is to increase the amount of the original investment by:
- earning a periodic cash flow and/or
- earning a gain in the value of assets (making a capital gain).
Assets need to be managed. Fund / portfolio management is the practice of asset allocation, i.e. the ongoing decision-making in respect of the allocation of funds between risky and non-risky assets, as well as choosing specific assets within asset classes. It is a balance between risk and return. The asset allocation function is based on in-depth asset market research.
Investment is not gambling. Gambling is a game of chance in which the probability of loss (= risk) is high. With investments the probability of loss can be small because there are methods of investment management to reduce risk and enhance returns.
Investment is also not speculation. Speculation is investing own and/or borrowed funds for short-term periods (often intra-day), and the probability of profit is substantially higher than with a gamble. This is so because it is founded on research (technical and/or fundamental). However, the risk is lower than in gambling and higher than in long-term investing.
The risk-free rate (rfr) is a concept that occupies centre-stage in investments / finance. It is a concept that some scholars have difficulty in defining (some have even said that it does not exist). In our view there is not one rfr, but a series stretching from the one-day treasury bill (TB) rate to the 30-year rate (ytm) on government bonds; "it" is simply the rates on government securities (treasury bills and government bonds), which are available daily (in efficient money and bond markets) and you can choose whichever rate you require as a benchmark for an investment.
What does this mean? It means that the rfr is the lowest rate that can be earned with certainty, and that you (when considering an investment for 5 years, for example) should regard the current 5-year bond rate as the minimum return you are willing to accept. It follows that every non-government, i.e. risky, investment should deliver a return [call it your required rate of return (rrr)] equal to the rfr plus a risk premium (rp):
This simple formula should be the starting point when consideration is given to any investment.
What does risk-free mean? It means that if you purchase a government security, the rate at which it is bought is certain to be earned, and this is because governments don't default38 (since they have the authority to borrow and tax in order to repay and service their debt).
Thus, there are two broad investment categories: risk-free and risky assets / investments. Risk-free assets are government securities which deliver certain but lower returns. Risky assets are non-government securities (shares, corporate bonds, property, etc.) which deliver uncertain but higher returns (depending on the holding period). As we will show later, there is a positive relationship between return and risk.
Figure 2: 3-year and 10-year bond rates
Figure 3: share prices (over 50 years)
However, it is important to mention that risk-free assets are only credit-risk-free - as said, because government has the power to tax and borrow funds. They are not market-risk-free if they are sold before maturity. What does this mean? It means that the return is only certain if the asset is not traded in the secondary market. Market prices are opposite to market rates, and if the market rate rises to a higher level than the purchase rate, the price will be lower, and a capital loss will be made. However, this is irrelevant in the sense that the rfr just acts as a benchmark return.