by Derin Adebayo

So you have some free cash lying around (lol, I know…. let’s just pretend you do) and someone approaches you while you’re jogging and tells you about an investment opportunity in his insurance company. For a fixed monthly deposit of NGN 50,000 you get NGN 3,000,000 after three years. Is this a good investment? Discuss (30 marks).

1. Yes
2. No
3. It depends

If you answered “yes”, you’re wrong. If you answered “no”, you’re wrong. The correct answer is “it depends”. It depends on what? You may ask. Judging investments can be complex and difficult to some people, but luckily for you I’m here to help you simplify it.

There are three main criteria to judge any investment opportunity, from putting your money in the bank, to investing in derivatives based on the price of oil in two years time, they all can be evaluated by these three criteria.

That’s enough for part one of this post. I’ll reveal the criteria in part two. Find part two on my personal blog (You’ll have to pay a small fee to access my blog).

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Lol, ok….. Let me tell you the criteria.

Return on Investment (ROI)

This goes by many names(interest, profit etc) but it is basically the extra money you make besides the initial amount that you put in an investment. If you invest N 100,000 in a fixed deposit account and at the end of the year, your bank pays NGN 2,000 extra into your account, your return on investment is calculated like this:

2,000/100,000 * 100 = 2%

ROI is usually the one thing that everyone considers when evaluating an investment. Is it the most important criteria?(15 marks)

1. Yes
2. No
3. It depends

If your answer was “Yes” you’re wrong. If you tried to be smart and chose “It depends”, nice try, but the you’re also wrong. The answer is “No”, because all the three options are equally important.

This will be clear as we explore the other two criteria.

Risk

Risk is the chance that you lose some or all of your original investment. This is hard to quantify as an actual number, but it is a concept you should understand and apply while evaluating any investment opportunity.

In every investment, there is an element of risk. If you put your money in stocks, the stock can go up or it can go down. If you put your money in the bank, the bank can go under and your deposit may be lost. If you invest in real estate, as the 2008 financial crises showed, real estate prices don’t always go up.

Liquidity

Liquidity is the ease of getting your investments as cash when you need them and at a known price. It’s no use having an investment with 100,000% ROI and little risk, if you can only get your money back after 100 years.

If you put your money in the bank, you can walk into the bank, or to an ATM and get your cash in a few minutes and you know exactly how much you can get. This is why cash is the most liquid investment you can hold. If you invest in a start-up you probably cannot get your money until the start-up starts making profit, lists on a stock exchange or is acquired. All these things will most likely take years before they happen. This is why investing in early stage companies is one of the most illiquid investments you can make.

It is important to understand how these three factors interact and influence each other. The higher the ROI on an investment, the more likely it is high risk, very illiquid or both. These applies to the other two factors also. Let’s consider a few common investment options and how they can be evaluated with this.

Cash In The Bank

As I mentioned earlier, cash in the bank is extremely liquid. It is also very low risk, the chances of your bank collapsing and running away with your deposits is really low. I know Godwin Emefiele’s CBN doesn’t exactly inspire confidence right now, but you can trust the banking system with your deposits. In terms of ROI is where cash in the bank falls short, ever noticed your bank pay some pitiful amount into your savings account and call it interest? Lol, it’s usually barely even enough to cover the cost of bank charges.

1. ROI: Very Low
2. Liquidity: Very High
3. Risk: Very Low

Stocks

Stocks represent ownership of a part of a business, you are entitled to a share of the firms profits, known as dividend and the price of a stock can also rise. The dividend and price appreciation combine to form your ROI.

Stocks are freely traded on the stock exchange, and the prices are easily available. This makes stocks also a very liquid investment option.

Generally, in the long run, the prices of stocks tend to appreciate at a good rate. Also most companies pay out dividend regularly. Therefore, stocks are usually a high return investment. Notice the words in bold, there is a lot of risk in investing in the stock market.

Now, the dividend depends on the earnings of the company in the previous year and the price of the stock depends on the opinion of investors on the future earning potential of the company. This means that dividends and prices are not easily predictable and that is why investing in the stock market can be risky.

1. ROI: High
2. Liquidity: High
3. Risk: High

Investing In Early Stage Businesses

If your friend is starting a shoe manufacturing company and asks you to invest NGN 10,000,000(lol, I know…. let’s pretend you have it) in his business for a stake in his business(let’s say 30%). You know your friend is a mixture of Bernard Arnault and Ralph Lauren, with a little Giuseppe Zanotti sprinkled on top, so you give him the money. You now hold 30% of a potential billion dollar company. Now, that’s an extremely high return for your initial investment.

Now you also know that 9 out of 10 new businesses fail, and for every Bernard Arnault, there are 9 Lorenzo Pianzino’s. Who is that? you ask. My point exactly. Investing in early stage companies is very risky, and it will take a long time before you can get any of your money back(if ever).

1. ROI: Very High
2. Liquidity: Very Low
3. Risk: Very High

Conclusion

Now you have the tools to evaluate our example from the first chapter. Some more information about the investment that I didn’t add. You cannot get your money until the end of the three years(low liquidity) and if you miss a payment you lose all you’ve paid till date(high risk?). Now you have enough information to make a decision.

You can also use this framework for evaluating other investment options like government bonds (Low Risk, Low ROI, High Liquidity), foreign exchange(Very High Risk, Very High ROI, High Liquidity) etc.

A few more things to consider. If you don’t fully understand an investment opportunity the risk immediately goes up by an order of magnitude. So if you can not answer the following questions, you probably don’t know enough to evaluate an investment.

1. What will my money be used for?
2. How will my ROI be generated?
3. Who will generate my ROI?
4. What institution(Zenith Bank, Nigerian government etc) is holding my money.

Finally, There’s no such thing as a free lunch. If someone offers you an investment with high ROI, no risk and high liquidity, you should probably walk away.

If it seems too good to be true – it probably is.

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Op–ed pieces and contributions are the opinions of the writers only and do not represent the opinions of Y!/YNaija

The author can be reached on twitter @DerinAdebayo.