If you’re lucky enough to get a bonus or 13th cheque, pause for a moment to think of the best investment option.
Deciding on an investment is almost like buying clothes: You see a pretty shirt but once you try it on, it doesn’t fit properly or suit your body. And, no matter how nice the shirt looked in the shop window, you wouldn’t buy it. In the same way, a financial product should suit your objectives and needs before you enter into a transaction.
Here are three basic concepts to understand:
1. Effective Interest Rate
If you compare the interest that a product will earn, it’s very important you compare apples with apples. Interest can be compounded at different frequencies: yearly, half-yearly, quarterly or monthly. For example, if you invest R1 000 for a year at 10 % per year, compounded monthly, you earn R104,71 interest. But if the interest is compounded twice yearly, you’ll earn R102,50 for the same period. In this example, the nominal interest rate is 5 % but that doesn’t take into account the effect compounding has on the end result.
How do you know which of these products offer a better return?
• Product A pays 8 % interest per year compounded monthly.
• Product B pays 8,05 % interest per year compounded half-yearly.
You should use the effective interest rate to compare the products. It’s a measure that takes into account the effect the compounding frequency has on the return. Thus, for Product A, the effective interest rate is 8,3 % and for Product B it’s 8,21 %.
By comparing the effective interest rate, we can see that Product A offers a better end result. If you compare products with a different nominal interest and compounding frequency, you need to compare the effective interest rate of each product and not the nominal interest rate.
2. Real Rate Of Return
This is the rate of interest you earn on a savings or investment product after you take inflation into account. If you receive 6 % interest per year on your savings account and the inflation rate is expected to be 5 %, your real rate of return is only 1 %. The real rate of return is a measure of the increase in your purchase power because of the investment.
For example: Mpho decides to put R1 000 away on her son’s 11th birthday to buy him a bicycle worth R1 000 for his next birthday. She earns 5 % interest per year on this amount, so she’ll have R1 050 after a year. However, inflation is also at 5 %, meaning that when Mpho buys the bicycle a year later, it now costs R1 050. By investing the money at the same rate as inflation, Mpho was not able to increase her purchasing power. If inflation was only 2,5 %, Mpho would have paid only R1 025 for the bicycle and would have still had some money left to buy some other things.
So it’s very important to consider the current inflation rate when deciding on an investment tool.
This is a measure to determine how easily you can access funds when needed. Many investments require you to complete paperwork before you can get your money. Or, there might be a stipulated notice period linked to a product if you want to withdraw your money. It’s best to determine in days how long it will take for you to have your money on hand for each product you consider, to make a comparison easy.
For more investment definitions, visit www.investopedia.com