Musaffa has introduced the investment checklist feature to help Muslim investors make sound investment decisions. Whenever you invest, you must have one expectation: a return. Investment is only worth the risk if you get a return. Understanding the risk and return of stock investing is essential to understand better what to anticipate from such investment. Below, we list four metrics that you should consider before making an investment decision
1. Expected return
When making an investment, you often want to know how much money you can expect to earn. Investors use the expected rate of return to understand what to expect from their investment. The expected rate of return is a calculation used in investing in estimating an investment’s potential earnings. It is determined by using the probabilities of different outcomes for the investment.
To calculate the expected return, you need to consider various scenarios in which the asset could gain or lose money. The sum of the product of the amount of gain or loss by the individual probability of each scenario will give you the expected rate of return.
The formula for the expected rate of return is:
where R is the rate return in a given scenario, P is the probability of that return for each scenario, and n is the number of scenarios.
For example, for the given investment opportunity, if there is a 45% chance of a 20% return, a 50% chance of a 10% return, and a 5% chance of a 10% loss, the expected return can be calculated by plugging these values into the formula. The expected return in this example would be 13.5%.
Expected Return = (45% x 20%) + (50% x 10%) + (5% x ( -10%)) = 9% + 5% + (-0.5%) = 13.5%
However, you should remember that past performance does not guarantee future performance. Investors should be cautious and not base their investment decisions solely on expected returns.
2. Stock Volatility
Your risk tolerance, also known as “risk level,” is a measure of how much uncertainty or potential loss you are willing to accept in pursuit of a potential gain. It is determined by the volatility you are willing to tolerate in your investments, with riskier stocks having the potential for higher returns and more significant losses over time.
When you invest in the stock market, be prepared for price fluctuations. The stock market is dynamic, and it constantly moves. Also, it’s important to note that individual stocks within the market may not perform the same; some may have more drastic price changes than others.
Beta is a statistical measurement that compares a stock’s volatility to the overall market’s volatility.
- A stock with a beta of 1 is expected to move with the market; while
- A stock with a beta of less than 1 is expected to be less volatile than the market; and
- A stock with a beta greater than 1 is expected to be more volatile than the market.
Beta provides a helpful way to compare the volatility of a specific stock to that of a market index, but it should not be considered a comprehensive measure of risk. It’s important to remember that volatility can have both positive and negative implications. Investors who prioritize earning income and are more risk-averse may avoid stocks with high beta, while those with a higher risk tolerance may be more attracted to them.
3. Sharpe Ratio
Evaluating investments based solely on projected return does not provide a complete understanding of the investment as it does not consider the amount of risk taken on those returns. The Sharpe ratio is an investment tool used to evaluate the performance of investments by considering the risk involved.
The Sharpe Ratio, introduced by William Sharpe in 1966, is a widely used risk-return measure in finance and is known for its simplicity. It provides investors with a score that reflects the risk-adjusted returns of an investment. It can be used to evaluate past or future performance, helping the investor determine if the returns result from good decision-making or excessive risk-taking.
The Sharpe ratio is calculated by dividing the difference between an asset or portfolio’s expected or actual return (Rp) and the risk-free rate (Rf) by dividing it by the investment’s standard deviation. The standard deviation is a measure of risk based on volatility. A lower standard deviation means less risk and a higher Sharpe ratio, while a higher standard deviation implies more risk and a lower Sharpe ratio.
When comparing two portfolios, it is important to consider their expected return and the risk involved. For example, Portfolio X is expected to give a 15% return over the next 12 months, while Portfolio Y is expected to deliver a return of 10% over the same period. At first glance, Portfolio X is the better choice based on returns alone. However, when considering risk, the Sharpe ratio provides a more comprehensive view of the investments.
Let’s assume that Portfolio X has a standard deviation of 9% (more risk), Portfolio Y has a standard deviation of 4% (less risk), and the risk-free rate is 3%, the yield on a medium-term U.S. Treasury security.
Portfolio X: (15% – 3%) / 9% = 1.33
Portfolio Y: (10% – 3%) / 4% = 1.75
By calculating the Sharpe Ratio for each portfolio, Portfolio Y has a higher score of 1.75 than Portfolio X, with a score of 1.33. This tells us that Portfolio Y provides a better risk-adjusted return.
The Sharpe ratio is commonly considered good if it falls between 1 and 3, and excellent if it is higher than 3.
4. Dividend Yield
The dividend yield is a financial ratio that measures the amount of a company’s annual dividend payments in relation to its stock price. It is typically expressed as a percentage and is calculated by dividing the annual dividend per share by the current stock price per share.
The resulting percentage shows the return on investment in the form of dividends that the investor would receive if they bought the share of the stock at a current price. For example, if a company’s stock trades at $50 per share and pays an annual dividend of $1 per share, the dividend yield would be 2% (1/50). This means that an investor would earn a 2% return on their investment in the form of dividends if they were to buy shares of that stock at its current price.
Several factors affect the dividend yield, such as the company’s industry and growth stage. For instance, fast-growing companies may reinvest in their business instead of paying dividends, while a mature company may have a higher yield due to limited growth prospects.
Remember that dividends aren’t guaranteed, so it’s essential to consider the company’s financial stability and historical dividend payment record before investing. Additionally, the yield ratio should not be used as the sole indicator of a company’s performance but rather as an investment metric to evaluate which stocks align with their investment strategy.
How Musaffa helps you make your best investment decision?
We understand that determining the halal status of a stock is an essential aspect of investing for Muslim investors. To assist with this, we have introduced a new feature called the investment checklist and forecast. The checklist includes essential metrics such as Expected Annual Return, Beta or Risk Level, Sharpe Ratio, and Dividend Yield.
Additionally, the forecast feature provides predictions for the price per share, revenue per share, and earnings per share for the next 12 months. Although it is impossible to predict the stock market with certainty, these metrics can serve as indicators to help identify higher or lower-risk situations.
Visit Musaffa Academy to read more interesting articles about halal investing.