An investment is a placement of money for financial gain are not guaranteed, that is, an investor risks a loss of principal in exchange for an opportunity to make a profit. A return on investment should, therefore, be measured against downside risk and risk-free return on investment guaranteed.
Certain financial products and investments are guaranteed against losses. Bank deposits are federally insured; the values of the United States Treasury are guaranteed as to timely payment of interest and principal; some municipal and corporate bonds are insured privately regarding timely payments of principal and interest; fixed annuities are guaranteed by insurance companies that issue them. A warranty is only as good as the guarantor’s ability to perform, and each has a limited warranty, but a starting point for evaluating the performance of the investment is to compare their growth potential to a guaranteed risk-free return. Investors take risks only if they have to: risk if they can get 3% risk-free, no reason to risk your money in an investment that has the potential to return the same 3%, but with the downside risk.
Risk versus reward
The growth potential should be compared with the potential disadvantage. Investors often use historical returns to guide them. An investment whose growth potential is greater than the floor offers a yield reasonable, regardless of the absolute numbers. On the other hand, if the investment offers a 10% upside, but the downside is 20%, your return may be reasonable in absolute terms, but the potential disadvantage makes it a poor risk.
Duration and Liquidity
The return should be proportional to the length of time an investor expects to recover their money and the ease with which you can convert into cash without the need to suffer excessive loss. An investment that requires 10 or 20 years of commitment should offer a higher than an investment that can be converted into cash instantly return. For example, a 4% return on investment that requires a commitment of 10 years may not be reasonable, even when compared with an account in the bank money market which pays 1%.
Compare apples to apples
Different types of investments offer different potential returns. It is important to compare the return on an investment with other investments in the same category. For example, the potential return of stocks is much higher than that of bonds proportionately riskier pipelining therefore not reasonable to compare the potential of a Treasury bond of the United States with an action of weaker growth return. Both investments would have a reasonable expectation of profit, but the absolute numbers are very different.