BSB107 Chap.4 Investing: Risk, Return and Compound Interest
Investing: Risk, Return and Compound Interest
Two principles behind every investment
Topic 4 rests on risk and return, where a higher expected return comes with more risk, and on the time value of money, where a dollar today is worth more than a dollar later.
Diversification, asset classes and the ways investments earn a return follow from them.
From formula to function
Compound interest is calculated with FV = PV × (1 + i)n and its rearranged form, and in Excel with FV, PV, RATE and NPER.
Matching the period and signing the cash flows are the two habits the portfolio checks.
The portfolio's Week 4 sheet
The Week 4 sheet asks for an investment schedule, Excel formulas in specific answer boxes and a chart, and the presentation does not need to explain it.
Its hints are worth memorising: enter the rate correctly, match the compounding period to the rate, check the signs, show the final answer as positive, and do not round.
The same formulas return in Topic 5 for loans and in Module 2 for discounting a project's cash flows, so time spent here is repaid three times.
What this chapter covers
- 01
Risk, return and risk profiles
- 02
Diversification and concentrated portfolios
- 03
Asset classes and kinds of return
- 04
Simple versus compound interest
- 05
Future value and present value formulas
- 06
FV, PV, RATE and NPER in Excel
- 07
Inflation and purchasing power
Worked example · free
Simple and compound growth at the halfway mark
- +1Simple, 10 years: 10,000 × (1 + 0.05 × 10) = $15,000.
- +1Compound, 10 years: 10,000 × 1.0510 = $16,288.95, or =FV(0.05, 10, 0, −10000).
- +1Balance at the start of year 20: 10,000 × 1.0519 = $25,269.50.
- +1Interest in year 20 = 25,269.50 × 0.05 = $1,263.48, against a constant $500 a year under simple interest.
Key terms
- Diversification
- Holding a variety of investments that are not perfectly correlated in order to reduce overall risk.
- Simple interest
- Interest calculated only on the principal, so the amount is the same in every period.
- Future value
- What an investment or a loan will be worth at a chosen future date.
- Inflation
- A general rise in prices that lowers the purchasing power of each dollar over time.
- Index fund
- A fund that tracks a market or sector, typically with low fees, also called an exchange traded fund.
- Concentrated portfolio
- A deliberately narrow set of investments that accepts higher risk in exchange for the chance of higher returns.
Investing: Risk, Return and Compound Interest FAQ
Why must I enter the deposit as a negative number in FV?
Excel treats money you pay in and money you receive as opposite flows. The deposit leaves your hands, so it is negative, and the balance you will receive comes back positive; a missing minus sign produces a negative answer or an error.
When does compound interest beat simple interest by a lot?
The gap grows with both the rate and the time. Over a few years it is small, but over decades interest on earlier interest dominates: $10,000 at 5% for 20 years ends near $26,533 compounded against $20,000 simple.
How do I convert a RATE result into an annual rate?
If the periods are months, RATE returns a monthly rate. Multiply it by 12 to quote an annual rate, as the unit's guide does when a five-year monthly calculation returns about 1.16% a month, or roughly 13.9% a year.
What is the difference between an active and a passive investor?
Active investors search out particular shares to buy and sell them if they underperform. Passive investors hand their money to a fund that makes the choices for them in return for a fee, such as an index fund that tracks a market or sector.
What happens if my investment earns less than inflation?
Inflation lowers the purchasing power of each dollar over time, so a return below the inflation rate means you are effectively losing money even though the balance grows. The real test of an investment is whether it keeps ahead of rising prices.
Why is cryptocurrency described as riskier than property?
The key concepts note uses the pair to illustrate that some investments are inherently riskier than others. Under the risk and return principle the riskier asset should offer a higher expected return, but with a greater chance that the return never arrives.
Exam move
Type FV, PV, RATE and NPER until each argument order is automatic. For any problem, fix the periodic rate and period count to match compounding, then signs, then the function, and verify one result with the formula by hand. Chart a deposit schedule with dated axis labels, a title and a legend.
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