Question

Have you considered the trade-off between risk and return when making an investment? Did it change your investment? Do you expect a risk premium related to the level of risk? Lastly, why is the present value of a dollar more valuable than its future value?

Answer 1

An investor always faces a trade off between risk and return while considering investment decisions. Higher the risk in the portfolio, higher is the potential return possibility. Risk- return tradeoff changes the investment depending upon the level of risk tolerance, the years to retirement and the potential to replace lost funds.

An investor would expect a risk premium related to the level of risk as risk premium acts as a compensation for the higher uncertainty associated with risky assets. The various risk factors, such as exchange rate risk, finance risk, business risk, liquidity risk, and country specific risk, could harm the returns, therefore, the investors require adequate compensation in the form of premium for bearing such risks.

The present value of a dollar is more valuable than its future value because of the time value of money. Money has a time value because it can be invested to make more money. The variables such as inflation and interest rates affect the time value of money.  A dollar in the future will not be able to buy the same value of goods as it does today because of inflation.

The people earn certain rate of interest by investing their money. A dollar received today can be invested to make more money. Therefore, a dollar received today is more valuable than a dollar received in the future.