You just got a £1,000 bonus and would like to invest it somewhere to help towards your kids' education in the future. You're naive so don't know about risk adjusted return yet. You pick up a copy of the Financial Times and read about investment opportunities. One story tells of a man who bought drilling rights for £10,000,000 and has struck oil. Those rights are now worth £40,000,000. Another story tells of last week's lottery winner who, with £10 managed to get a jackpot of £18,000,000. A chart shows you that the S&P index was at 1,270 at the start of the year and now languishes at 1,155. Your bank manager tells you if you give her the £1,000 get £5 credited to your account each month.
If we pretend for a moment that your £1,000 is enough to allow you to participate in any of the above ventures, then you might ask yourself: which one would give me the most money for the investment. (As noted above, this isn't actually the question you should be asking yourself - you ought to be asking yourself which investment gives me the most new cash given my risk appetite).
Interest rates are just ratios. Ways of comparing how much additional cash you'd get for a nominal amount of, say £1 invested in a venture. With the oil rights, you get 400% return, with the lottery 180,000,000% return, with the equity index investment, you get -9% return (you lose that much of your capital, in other words) and with the bank account each month you'd get 0.5%, making approximately 6% in a year.
To really be fair, you'd like to know how long it takes for those investments to pay off as they did. For the bank account, you get 12 monthly payments. For the market, it took 10 months to get that far, and for the oil drilling company, ten years. For the lottery ticket, it took only 1 day. To re-capitulate, you started by being fair to the investment by asking how much a nominal amount (£1) invested would return to you, then you try to be fairer still by adjusting for the period of time you need to risk your capital. This second step is akin to viewing the investments across the same nominal time period (let's say one year). All you're doing is scaling the final cash returns by assuming a nominal investment for a nominal period. The annualised return for the oil investment is therefore 40%, for the lottery investment 65,700,000,000%, for the stock market -10.9% and for your bank, 6%.
These simple multiplicative steps in the name of fairness allow you to reduce the noise, to get closer to making an investment decision.
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