How to Compare Investments and Pick the Best One

There comes a time in our life where we are given a choice. Where shall we put the only finite money we have after long months of saving? Is the most popular stocks the best investment to put your money into? Or is it the cheapest stock that you can find?

Answering those questions is very hard. Because if we know the best investment, we will all be investing in that investment until a certain point that its not a good investment anymore. The more people know about a good investment, the less it becomes a good investment. So its in a value investor’s skill on how to see it first before everyone. Or the simpler way, see it the way it truly is, while other people are enamored with its greed.

To compare investments, you must first know what is the “risk-free” rate. Meaning, what is the rate of return for the safest investment you could find. Today, what we can call a risk-free investment is a government bond. Let’s say for example a long government bond has a coupon rate of 6%, that means, in order to get a better investment return, you must find something that has at least 6% return. Be it a dividend stock that gives 6.1%. The name of the game is to be better than the risk free rate.

Of course, we must not forget the risk in investing. If you can find a 7% return for your investment, you must next decide if the 1% difference in return from the risk-free rate is justifiable with the amount of risk in the investment. If you’re going to give your uncle a loan with 8% interest (better than the risk-free rate) you must next decide if your uncle is trustworthy enough because there’s a risk that he might not pay you back and lose all of your money.

This is what we are doing when value investing. Is it better to just buy bonds so we eliminate the risk of stocks? Or should we risk stocks? Is it justified for the risk taken? Its a balancing act. Buffett has talked about that the job of a value investor is to figure out the coupon in a stock, so you can compare it with a risk free rate. That’s the name of the game. For example, what is the coupon for the stock of MER? Is it better than the risk free rate? Or should we just give up and buy the bonds because stocks are much riskier for the amount of return we are going to get.

Of course knowing how to do that is not easy. That’s why you need to know how to invest.

A wise man once said, “If I’m taking risk, I must get paid.

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