Question

How do you make decisions that are expected to generate income?

At different stages of your life, you will evaluate investment options based on the expected cash flows that they are likely to produce – a process that hopefully will help you to make informed decisions. Think about the various way you might invest money to generate income in the future, and how you will make these types of decisions. For this assignment, suppose that you have been given $10,000 with the requirement that you "invest" it in one of the 3 different options below. Research the expected return and associated risk for each of the following:

• Pay down your student loan or credit card debt. Although this is not technically an investment, it is effectively the same as earning a "risk-free" rate of interest. Alternatively, you can keep the cash in a riskless (FDIC insured) bank account. Current rates are available on a number of different sites such as Bankrate.com.
• Invest in any stock(s) of your choice. Research the company on Yahoo FinanceLinks to an external site. or other financial site, and get statistics regarding the expected risk and return for this investment. Be very specific about why you selected this company.
• Invest in a real estate rental property. Research property prices, rents, and expenses for residential income properties or get basic information from a property management site such as Mashvisor. or Roofstock. Note that a "cap rate" or "cash-on-cash" return is like a dividend yield for a stock, and is calculated as net operating income (rental income less expenses) divided by the price.

There are no wrong answers, but you must justify your opinions using the concepts that you have learned in this course. Be sure to include all factors used in making your evaluations, and be specific about your conclusions. To receive full credit, your answers must be well thought out and well-written.

Answer ALL 4 requirements below:

1. Before making any calculations, which option appeals to you the most?
2. What methods would you use to evaluate these options? Compare each option in terms of current yield, potential for appreciation, and estimate an approximate long-term total return.
3. Which option offers the best potential return given its level of risk? Which one would you choose given your level of risk aversion? Explain in detail.
4. What sort of capital investments do you think you might make in the future? What other investments (such as owning your own company or investing in a start-up) would you consider? Why? Are there any factors in addition to monetary gain that you would consider?

Just need a brief response to each requirement if possible, thanks.

Answer 1

Let us look at the 3 options without making any financial calculations. Paying off student loan or credit card debt will reduce a liability. Note that the description that paying off the loan is equivalent to earning risk-free rate is a bit misleading. The loan has an interest rate associated with it and by paying that off early; we are saving or in other words, gaining that amount of interest every year. Moreover, the interest rate is fixed so this is like equivalent to fixed asset security. Picking one single stock for investing such a large amount is not advisable, irrespective of which stock you pick. Investment in stock markets need always be diversified, unless you have a long track record of picking winning stocks. Just because a stock has given consistently good returns in the past doesn’t guarantee the future returns. Hence, the portfolio should be diversified, probably by investing in ETF rather than a single stock. Investing in rental real estate is also a good option but direct real estate usually requires a ticket size much larger than the amount at hand. Additionally, the real estate market are very inefficient in terms of information flow (information asymmetry) and hence, one need to do a thorough research before actually purchasing a particular property. Investing in a REIT or a similar pooled vehicle is a much practical option. One important aspect before choosing an investment vehicle is the investment horizon. It is not specified for how long do we need to hold the investment. Hence, we can assume for it to be medium-term i.e. for 2-5 years.

Now let’s looks at the financial aspect-

	Expected return earned/ saved
Credit card debt	16%
Student loan	6.50%
S&P 500 ETF	8.50%
Google stock	4.50%
REIT (American Tower Corp)	12%
Average home (cap rate + appreciation)	9%

As we can see here that the range of returns is very high, which typically is in line with the risk associated with each of the investments. If you have a credit card debt, it makes sense to pay if off first since it charges a much higher interest rate than probably any other investment. Student loan is a bit cheaper as it is usually subsidized. It still makes more sense to pay off the loan first since the opportunity cost and fixed liability burden is often intangible from a loan like this. As mentioned earlier, it makes more sense to buy an ETF than any individual stock, considering the risk involved. Owning direct rental real estate has a yield of ~6% plus a chance of capital appreciation of 3-4%. However, the ticket size is too large considering the cash in hand. We can take a mortgage to finance the rest of the property value and this will drastically change the yield on the property, depending on the terms of the loan. Considering an average rate of mortgage at 5%, the net yield from rental property income is not as attractive. REIT has one of the returns among the listed investment options. It can also be accessed without leverage with the currently available capital. Since it is managed by the experts of this field, the chances of ill-impact from information asymmetry is considerably reduced.

Considering my level of medium to high risk aversion, I would choose to pay off the credit card loan, then invest in ETF and then invest in a REIT, in that order of preference. The first option provides a fixed save of 16% per annum while the other two options provide a diversification benefit to reduce risk.

In future, the choice of investment will depend on how big the amount to be invested is, in comparison to total portfolio or wealth at that point of time. I would always prefer to be as diversified as possible rather than invest in few focused assets. I would invest in a startup only if I can be a part of it and influence the management of the startup. In this case, the control over the company’s operations is equally important as monetary gains. In general, I prefer investing in stock market, either through ETFs or through few large and steady growth companies. It also allows investment in small ticket sizes and small transaction cost. It also allows for a systematic investment plans which promotes a disciplined investment.