When comparing different securities (like CD’s, bonds, and common stocks), why it is important to know?

When comparing different securities (like CD’s, bonds, and common stocks), why it is important to know what interest rate should be used in that comparison?

Best Answer

The earnings of an investment are the basis for comparison. If a CD earns 5%, corporate bonds earn 6%, and stocks increase in value by 10%, which would you choose? The CD is insured. The bond issuer has to pay the interest, but there is a risk of default. A stock could gain10% in one year then lose 11% the next year.

Opportunity cost. So you'll know what expected return you can get on one investment compared to another, considering risk.

The most important thing to know is determining the risk vs reward. How much risk you will have to take in order to get the reward you seek. CD's are basically risk free. They have the lowest possible reward. Bonds are more risky. But you have a set return. You will earn the interest on the bond. Stocks have the most risk of the three, but they have the greatest possible return. So it really get down to your appetiite for risk.

Interest is the opportunity cost of money. The alternative is you could spend it or hold it in cash. How much of a return must you have to part with your cash? If this were the early 1970's the interest rates were in the mid teens, would you accept something that provided a chancy 10% return for a guaranteed 15% return?

Interest is the comparison signal.

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